Want to earn passive income from a Stocks and Shares ISA? Here’s how

What’s the best way to go about building up the biggest passive income pot we can in an ISA?

Today’s Stocks and Shares ISA millionaires have something in common. They mainly put the bulk of their investment money into reliable companies generating strong cash flow and paying dependable dividends.

The masterstroke is to reinvest each year’s dividend cash in new shares, and then let it build up over the years. How much difference can the miracle of compound returns make? It could be enough to take our breath away.

Plough the cash back in

We’ve seen annual FTSE 100 returns averaging 6.9% in the past 20 years. That’s consistent with the longer-term history of the UK stock market stretching back more than 100 years.

It’s enough to earn £690 from a £10,000 investment in the first year. If we reinvest the profit, in the second year we’d expect a little bit more — we’d have 6.9% of the extra £690 to add to it. But it’s when we look at the years ahead that we see the big difference.

In the 10th year, we could expect a £1,258 return to add to our pot. By year 20 we could be looking at an extra £2,541 to add to the total. The 30th year could contribute a further £4,778. And by that time, the original £10,000 could have grown to £37,980.

That’s from a one-off investment. Invest £10,000 every year and we could see a fortune of £420,000 build up in 20 years. Or a million in 31 years.

Which stocks to buy

I haven’t looked at which actual stocks to buy. But ask different ISA investors and we’ll get different answers — even from the millionaires. So I’ll just look at one of my own choices as an example, and explain why I chose it in line with my own strategy.

It’s insurance giant Aviva (LSE: AV.), with a current forecast dividend yield of 5.9%. The share price has risen 120% in the past five years too, but we need to look futher back than that.

Over the past 10 years, Aviva shares are up only around 15%, which isn’t great. But it does illustrate the biggest enemy of short-term investing: volatility. The insurance business is notoriously cyclical and can be more volatile than most.

For me, I’d only invest in this sector if I planned to hold for at least 10 years. Even then, I’d be focused more on dividends than potential share price gains. And for a contrarian advantage, a more volatile stock means I get to buy more new shares with my dividends when the price is lower.

Diversify, diversify

The chance of that volatility extending, together with a lack of dividend cover, adds risk. And that reinforces the need for diversification. And that’s another key strategy of millionaire ISA investors who are today relaxing and enjoying their passive income.

So, buy cash-cow stocks, spread the risk across sectors, and invest as much as we can for as long as we can. That’s the recipe for psssive income success in my book.

The post Want to earn passive income from a Stocks and Shares ISA? Here’s how appeared first on The Motley Fool UK.

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Alan Oscroft has positions in Aviva Plc. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.