A Stocks and Shares ISA is a tremendous vehicle for building wealth in the stock market. That’s because its gains (share price rises and dividends paid) are tax-free.
With annual tax allowances being slashed aggressively next year, the power of an ISA is increasing. And to maximise its potential, I think investors should strive to inject as much as the £20k annual limit as possible.
However, even if an investor can spare £20k each year, the next challenge is figuring out where best to invest it. So if I were building an income ISA portfolio from scratch today, here’s how I’d go about it.
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Quality over quantity
If my goal is to build a lifelong second income in the stock market, targeting the companies with the biggest payouts sounds sensible. After all, the higher the yield, the greater the return, and the faster I grow my ISA, right?
Income investing isn’t that simple. While there are some exceptions, a high dividend yield is often a sign to stay away. Why? Because this metric can be easily manipulated by a rapidly falling stock price rather than an increase in shareholder payouts.
This creates income traps where an investor buys a dividend stock for passive income only to see payments slashed, or outright cancelled, a few months later. So if yield isn’t the answer, what is?
Cash flow. Specifically free cash flow to equity (FCFE). This is the money left over after a company has covered all of its operating, reinvestments and debt servicing expenses. In other words, it’s the capital a firm has available to:
- Accumulate as cash on the balance sheet
- Buy back shares
- Pay a dividend
By comparing the dividends paid to the FCFE, investors can quickly gauge if a company is generating enough money to afford its payouts. Suppose dividends are getting close to or exceed the FCFE? In that case, they may be at risk of going on the chopping block if cash flow gets disrupted.
Diversifying a portfolio
Even if an investor finds a terrific company with sustainable-looking dividends, there’s no guarantee it will stay that way. External disruptions can emerge with little warning. This can send even the best cash-generative businesses into becoming far more conservative with shareholder payouts.
That’s why diversification plays a critical role in building an income portfolio. By owning a variety of top-notch enterprises across multiple industries and geographies, the impact of one firm getting disrupted is mitigated by the others.
Even the most diversified ISA in the UK isn’t risk-free. Stock market crashes and corrections can smash valuations into the ground. However, historically diversified portfolios containing high-quality shares usually fare better and recover faster.
And the large number of millionaires who’ve made their money via their ISAs shows just how rich the rewards can be for investors who choose wisely.
