People use their ISAs in different ways. Sometimes, a Stocks and Shares ISA can be a helpful way to produce passive income streams for the coming months and years.
But an alternative is to use a Stocks and Shares ISA to try and build some long-term wealth. Here is how I would go about that.
Growth or income focus?
One way to build wealth for the long term is to find companies in their early stages that may have a great future ahead of them. If I can invest £20,000 today in shares that increase a hundred-fold over the next couple of decades, I would end up with a couple of million pounds for my efforts!
The difficulty with that approach is that, for every share that becomes a hundred-bagger, there are loads that do not even keep their value in the long term, let alone increase it dramatically. Even the most successful stock pickers often have a portfolio containing quite a few duds, alongside the star performers.
That is why I think a more realistic approach to building my long-term wealth could be to buy high income shares and continually reinvest the dividends.
The power of compounding
Why would I reinvest the dividends in my Stocks and Shares ISA? The reason is I want to benefit from what is known as compounding.
Warren Buffett illustrates compounding with a snowball. As the snowball goes downhill, it picks up more snow. Crucially, the snow it picks up then picks up more snow. That means that over time, it gets bigger and bigger as the growth itself produces growth.
If I reinvest dividends, I could try to get the same benefit. Imagine I invest £20,000 in shares with an average yield of 5% like Aviva and reinvest the dividends annually. Presuming the share price and dividends stay flat, after 25 years, my ISA would be worth over £69,000.
If I invested in shares yielding an average 7% like Legal & General, after 25 years my ISA value would be over £114,000. Even more dramatic is what happens if I invest in shares with an average yield of 10% like Persimmon. After 25 years, the £20,000 I put in my ISA today would have grown to £241,000.
Managing risk in my Stocks and Shares ISA
However, what happens if things change? After all, 25 years is quite a long time. Companies may cut or cancel their dividends. A quarter of a century from now, they may even have gone out of business altogether.
I try to mitigate that risk by spreading my Stocks and Shares ISA across a number of companies. I also am not buying shares purely for their yield. Instead, I ask myself what their long-term business prospects are like. Do I think they have the ability to make strong profits to fund their dividend payments years into the future?
By investing in carefully chosen income shares, I hope my Stocks and Shares ISA can help me grow my wealth in the coming decades.