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Generating a passive income is a financial goal shared by many, myself included. After all, who doesn’t like the idea of making money without needing to lift a finger?
There are countless methods to pursue this objective. But investing in the stock market, I feel, is one of the best wealth-building strategies today.
A common belief is that a lot of capital is needed to succeed as an investor. And there is some truth to that. But as it turns out, investing as little as £250 a month is enough to build a substantial long-term passive income for a comfortable retirement. Let me demonstrate.
Building a £32,000 passive income
The FTSE 100 is a popular index used to track the overall performance of UK shares. Historically, it’s generated an average annual return of around 7.8%. And investors buying an exchange-traded fund or index tracker have been able to tap into these returns with minimal effort.
However, it’s the FTSE 250 that’s caught my attention today. The index covers a broader range of businesses, many of which are smaller and therefore introduce significantly more volatility versus the FTSE 100. However, as a counterbalance, the growth opportunities within the index are far more substantial. So much so that the average return is closer to 11.6%.
That may not seem like much. But in the long-term, a few percentage points make a world of difference.
Suppose I were to buy shares in a FTSE 250 index tracker, and its performance continues into the future. In that case, a monthly investment of £250 would transform into just under £800,000 within 30 years. Following the tried and tested 4% annual withdrawal rule gives me a passive income of £32,000.
By comparison, if I followed the FTSE 100, my hypothetical portfolio would have only reached £358,000, or £14,320 passive income.
Taking a step back
As impressive as these figures sound, there is a giant caveat – the stock market is far from risk-free. I previously mentioned, the FTSE 250 is more volatile than the FTSE 100. To put this in perspective, since the start of the ongoing stock price correction this year, the FTSE 100 has dropped 1%. On the other hand, the FTSE 250 is down 16%.
With greater returns comes greater risk. And within the next 30 years, multiple corrections and crashes will almost certainly happen. Depending on the timing, this could derail the wealth-building process. In other words, it may take much longer than 30 years to hit my passive income goal.
Needless to say, this risk is even more amplified if I choose to go down the route of picking stocks directly. This option once again opens the door to even higher returns. But it comes at the cost of elevated risk, especially in the short term.
If I can’t identify solid investment opportunities, I’ll likely end up destroying wealth rather than creating it. But it can be well worth the effort if I’m successful in picking future industry leaders. Even if my average return only improves to 13%, the resulting passive income would jump to £44,000 a year.
That, in my opinion, is worth the risk for my portfolio.