How I’d invest a £20K ISA to target £1,600 in annual passive income

Not all passive income ideas are passive. That’s one of the reasons I like investing in stocks.

I can (and really have) put some money into shares like that British American Tobacco and Dunelm, then sit back and wait for these companies to send me a slice of their profits. I hope this happens regularly.

But since dividends are never guaranteed, I try to increase my income prospects by diversifying my investments in different businesses.

You can try and target specific targets using this approach. For example, if I have £20,000 in a Stocks and Shares ISA and want to aim for an annual passive income of £1,600 from dividends alone, here’s how.

the shelves are empty

Sometimes I imagine my portfolio as a cabinet with many shelves. In this case, it can have five to 10 shelves. I want to split my money evenly, which means I put £2,000-£4,000 into each company.

That approach helps me diversify, which is an important risk management principle to use when creating a passive income stream.

Money plant

Looking at the empty shelves, everyone needs something.

Some people may be tempted to put in what might be called a leaky jar – a pot of money that is quickly spilling over. At first, it may seem tempting, because it is a waste of money. But without a way to change what is being paid, these payments may not be sustainable. That metaphor explains why I don’t invest in stocks just because they currently have a high dividend yield. They can be value traps.

However, I am looking for something closer to a money plant. I mean something I can put on an empty shelf that will hopefully make me money now and continue to do so in the future. That’s how I think about good and profitable businesses that can support dividends, because of healthy business performance.

Furnishing shelves

Therefore, I will focus my search for passive income streams to find great companies whose shares I can buy at an attractive price. This may take time, so I’m not in a hurry.

Just because my decision process doesn’t start with yielding dividends doesn’t mean I’m ignoring everything. I may decide to buy shares in large companies that I feel will help me reach my income goals, while passing up other investment opportunities that seem more growth-focused with lower income prospects.

Alphabet precedent. I think parent Google is a good business. But I don’t expect to be paying dividends anytime soon, so I won’t buy it for my ISA if income is my goal.

Build a passive income stream

Instead, I will build an income portfolio focused on large companies that I also expect to meet my return targets. Generating £1,600 in passive income required me to make an average profit of 8%.

Some of the stocks I own now give higher yields than, like M&G and apart. As the target is average, I can aim to hit while still buying some shares with lower yield as long as I generate the right level of the overall dividend.