One of the things I like about investing in a Stocks and Shares ISA is the potential for dividends. Many UK share prices have fallen recently, pushing up their dividend yields. Here is how I would seek to take advantage of that in my ISA.
The passive income potential of shares
A lot of companies throw off more money than they need. While some use profits to buy other firms or pay down debt, some companies effectively gush money with no real use for it. That can be lucrative for shareholders if it is paid out in the form of dividends.
An example from my own portfolio is the financial services firm Direct Line. Currently, the Direct Line dividend yield is 11.5%.
Earning income from my ISA
Indeed, that income potential is a key reason that I own Direct Line in my own Stocks and Shares ISA. If I invested £20,000 at an average yield of 11.5%, I would be on track to earn £2,300 in dividends each year.
But Direct Line could disappoint. After all, in the past year its share price has sunk 30%.
Perhaps that reflects investor concerns about the impact of rising vehicle costs on the claims bill for insurers like Direct Line. If that hurts profits, the dividend could be cut. No dividend is ever guaranteed.
Diversifying my investments
That is why Direct Line is not the only share I hold in my ISA. Instead, I hold a diversified selection of companies in different industries. That helps reduce the risk to my portfolio value and passive income streams if any one company turns out to be disappointing.
Still, right now, there are a number of companies I find attractive that have yields similar to that of Direct Line. So I may still be able to get the same average yield from a diversified portfolio as that currently offered by Direct Line.
Growing dividend streams
But how can I aim to grow my annual dividend income without putting more money into the ISA? I see two main ways.
One is to invest in shares I expect to raise their dividends annually. That is partly why I own shares in British American Tobacco. It has raised its dividend annually for over two decades, although I do recognise that falling cigarette usage in many markets is a risk to future profits and dividends.
A second way is to compound my dividends. This means that instead of taking the dividends out as cash, I leave them in my Stocks and Shares ISA and use them to buy more shares. These can therefore effectively earn their own dividends in time.
If I invested £20,000 at an average yield of 11.5% and compounded my dividends annually, after a decade the annual income from my Stocks and Shares ISA should have risen to £6,830. That example presumes constant share prices and dividends, but the principle is clear.
Compounding could help me grow the dividends I earn in my Stocks and Shares ISA even — without putting any more money into it.