What sort of companies should investors buy in their Stocks and Shares ISA? The answer varies depending on an investor’s objectives and risk tolerance. However, for those seeking some passive income, holding dividend shares inside an ISA is a proven and lucrative strategy.

With that in mind, let’s explore how to start earning £500 each month when starting from scratch.

Unlocking an ISA income

On average, the UK stock market typically delivers around 8% in total returns each year. At least, that’s what the long-term performance of the FTSE 100 indicates. And the general rule of thumb is to withdraw only around 4% of a portfolio each year for passive income. That way a portfolio can still grow over time.

Let’s stick to this constraint. Withdrawing £500 a month is equivalent to £6,000 per year. And by following the 4% rule, that would require an investor to have a Stocks and Shares ISA worth £150,000.

Obviously, that’s quite a bit of money. But the good news is, even for those starting from zero, it’s not an unobtainable sum if investors are willing to be patient. By consistently drip-feeding money from a monthly salary into an ISA, it’s possible to reach this six-figure threshold within a few years.

Let’s say I were to put £500 to work each month. At an 8% annualised return, my portfolio would reach the £150,000 target within 14 years. Obviously, this is a bit of a long wait to earn some meaningful passive income. Fortunately, there are two tactics investors can use to shorten this timeline.

Accelerating wealth building

Instead of investing £500 each month to build a £150,000 portfolio, I could contribute more. This is by far the easiest way to accelerate the wealth-building journey. And by maximising the annual ISA contribution limit, the timeline could be reduced to just six years.

Sadly, not everyone is fortunate enough to have a spare £1,667 each month. That leaves us with option two: increase the rate of return with stock picking.

Rather than investing in the whole FTSE 100 via an index fund, investors can choose to own individual companies directly. And when this strategy is executed intelligently, the returns can be significantly larger. Take Diploma (LSE:DPLM) as an example.

This logistics and distribution enterprise plays a crucial role in helping companies in the aerospace, biotech, and industrial industry maintain their supply chains. So, it’s hardly surprising that Diploma has vastly outperformed the FTSE 100 over the last 10 years.

Including dividends, this stock has delivered a total annualised return of 22.6%! And investing £500 at this rate of return, would translate into £150,000 in less than nine years.

Everything has its risks

Not all FTSE 100 stocks have been as successful as Diploma. In fact, there have been plenty of businesses that vastly underperformed over the same time period. Some have even fallen into the realm of bankruptcy. Stock pickers are far more exposed to these types of risks. And even Diploma has had its fair share of challenges over the years, including ample competition – a threat that remains today.

Nevertheless, risk can be managed with tactics like diversification. And by being selective and shrewd, investors could uncover the next Diploma-like stock that sends their Stocks and Shares ISA flying.