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A Stocks and Shares ISA is a long-term investment vehicle.
Different investors use it in different ways. Some want to target capital growth by buying shares cheaply and later selling them for a profit. Some focus on passive income: a regular stream of dividends, or putting the dividends to work to try and earn more income down the road.
So, how much passive income could a £20K Stocks and Shares ISA realistically have earned over the past decade?
The straightforward dividend approach
One variable is the average dividend yield. I will use three to illustrate: the current FTSE 100 average of 3.6%, then 5% and what I see as a high yield, 8%. In today’s market, I think both 5% and 8% are possible while sticking to carefully selected blue-chip shares.
Taking dividends out as they are paid, over a decade, 3.6% would have generated £720 each year – a total of £7,200 over a decade.
Five percent would have been £1,000 each year – a total of £10,000 in a decade. At 8%, the ISA would generate £1,600 a year in dividends. That means the £20K would have generated £16K of passive income over my chosen timescale.
On top of that, an investor may benefit from capital gains when the price goes up (although share prices can fall as well as rise).
Taking the Warren Buffett approach
A second approach is to do what billionaire investor Warren Buffett does.
He has run Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B) for decades but during his tenure it has only paid one dividend. That is despite it generating huge cash flows thanks to owning a lot of successful businesses outright while also holding shares in steady dividend payers like Coca-Cola.
It makes sense for Berkshire to keep some cash on hand. It operates in the insurance industry and there is always a risk that an event — like a hurricane — could suddenly push up its short-term cash needs to meet claims. But Berkshire has hundreds of billions of dollars of cash on hand today!
Rather than doling it out as dividends, Buffett aims to put it work to try and earn even more money in future, by making more investments (although the current cash pile means Berkshire hasn’t done as much of that lately).
Compounding an ISA
A similar approach (known as compounding) can be applied to the dividends received in a Stocks and Shares ISA.
Compounding a £20K ISA at 3.6% for a decade, it would be worth over £28,400 – enough to earn £1,025 in dividends at a 3.6% yield.
Compounding at 5%, the ISA would be worth over £32,500 after a decade. That could then earn around £1,628 each year in dividends.
Meanwhile, compounding the £20K ISA at 8% for 10 years, it would be worth over £43K and could then earn £3,454 in passive income annually.
Compounding would have meant sacrificing dividends for a decade but hopefully earning bigger ones from this year onwards (or whenever the investor chose to stop compounding and start withdrawing).
Selecting the right shares is key, but the costs of a Stocks and Shares ISA can eat into overall returns, especially over the long run. So a savvy investor will start by comparing different ISAs on the market and decide which one suits their needs best.
