The earlier an investor starts buying shares, the more scope they will have for compounding to produce a large nest egg that can provide a passive income in retirement.
Certainly, there will be challenges along the way. The 2020 stock market crash was a reminder that shares can fall heavily in a short space of time.
However, by investing regularly through such periods, it’s possible to obtain a high return relative to other assets. And with it, a surprisingly large retirement portfolio.
A long-term investment horizon for a passive income
At age 40, most people still have a long time horizon when it comes to planning for retirement. After all, they’re unlikely to require a passive income from their investments for 25 years or more. This provides sufficient time for compounding to make a real impact on their returns.
For example, the FTSE 250 has produced an annual total return of around 9% over the past 20 years. Investing £500 at that same return over a period of five years would lead to a portfolio valued at £38,000.
However, over a 25-year period, the same investment each month at the same return would be worth £565,000. As such, the sooner investments can be made, the more opportunity there is for the stock market’s historic high single-digit returns to build a worthwhile portfolio by retirement.
From a £565,000 portfolio, a 4% annual withdrawal would equate to a passive income of £22,600. That’s more than twice the current State Pension, and could provide greater financial security in older age.
Investing through stock market crashes
As mentioned, the stock market will not always produce 9% annual total returns. There may be some periods where its returns are negative – potentially by a large amount. Such periods have occurred fairly regularly throughout history.
While it’s natural for an investor to avoid buying shares during such periods because of the fear of further falls, it’s important to maintain a regular investment throughout a long time period. Doing so allows an investor to capitalise on lower valuations that may only be around temporarily in a bid to benefit from a very likely long-term recovery. This may lead to a larger retirement nest egg and a more generous passive income in older age.
For example, many stocks haven’t yet recovered from the 2020 stock market crash. In some cases, they face challenging near-term outlooks. This may dissuade some investors from buying them, since they could realistically produce negative returns in the short run.
However, many of today’s cheap shares have the financial strength to recover from short-term economic challenges to post improving profitability. As such, now could be the right time to start investing money in them. Over time, they could produce high returns that improve an investor’s passive income in retirement.
