There are plenty of ways to go about building a passive income. But investing in the stock market remains one of the best options, in my opinion.
It requires far less hassle than buying real estate or starting a business. And, more importantly, I don’t need large sums of capital to get the ball rolling. In fact, even if I can spare just £500 a month from my salary, it’s possible to build a seven-figure nest egg paired with a substantial annual passive income in the long run.
Building a £56,000 passive income
With the invention of low-cost index tracker funds, it’s easier than ever to start investing in the stock market with minimal knowledge. These types of financial instruments allow me to buy a small piece of every business inside an underlying index within a single transaction.
Two of the most popular indices in the UK are the FTSE 100 and FTSE 250. The latter is a bit more volatile but has a better track record of higher returns. In fact, over the last decade, the FTSE 250 index has generated a total annualised return of around 11% versus the FTSE 100’s 8%.
A 3% difference may seem insignificant now. But when compounded over decades, it can have a profound impact on my passive income portfolio.
Let’s assume the FTSE 250 can continue to deliver an 11% annualised return over the next 30 years. If I invest £500 a month throughout this period, I will have put in a total of £180,000. But thanks to my investment returns, the total value of my portfolio would stand at a whopping £1,402,260.
By comparison, tracking the FTSE 100 with its lower 8% annualised return will place my future portfolio at around £745,180.
That’s the power of a 3% difference in the long run. And following the classic 4% annual withdrawal rule on a £1.4m portfolio yields a passive income of £56,000.
Nothing is risk-free
The idea of simply throwing money into an index tracker to become a millionaire certainly seems a bit too easy to be true. But while being a successful long-term investor can really be that simple, it doesn’t come risk-free.
My earlier calculation made the fundamental assumption that the FTSE 250 can continue delivering its historical returns moving forward. In reality, this is impossible to guarantee. And 2022 has perfectly demonstrated just how volatile the stock market can be, with the FTSE 250 dropping by over 25% in a single year!
Sadly, crashes and corrections, while rare, do happen. Plus, chances are my portfolio will see similar events multiple times throughout the next three decades.
Needless to say, that could seriously impact my annual returns. And depending on the timing of these events, my nest egg, along with my stream of passive income, could become severely compromised. At least in the short term.
But with prudent financial planning, weathering these storms, even during retirement, is entirely possible. That’s why given the potential rewards, I believe investing in the stock market is a step worth taking.