How I’d try to create £105,000 in passive income by investing just £400 a month!

Dr James Fox explains how he’d use a compound returns strategy to build wealth over 35 years and generate passive income in retirement.

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By investing in UK stocks, and by being patient, investors can create considerable wealth and generate life-changing passive income. For me, passive income is one of the main objectives of investing.

But I don’t need the money right now. Instead, I’m using a compound returns strategy to build wealth over the long run. After a few decades, when my pot has built up, I can start drawing down.

While the FTSE 100 offers strong returns, good quality mid-cap and even small-cap stocks can deliver big returns, unlocking sizeable income streams.

Unlocking impressive returns

The FTSE 250 is a capitalisation-weighted index consisting of the 101st to the 350th largest companies listed on the London Stock Exchange.

Over the last two decades the mid-cap FTSE 250 has provided a higher return than the FTSE 100, despite smaller dividend yields.

In fact, since its inception in 1992, the FTSE 250 has delivered an average annualised total return of 10.6%. That’s despite a correction in 2022. The index has also achieved over a 600% total return since 1998.

Compound returns

A compound returns strategy involves reinvesting my dividends and earning interest on my interest. Essentially, it’s very much like a snowball effect.

So how could I make this work when investing in FTSE 250 stocks? Well, let’s assume I invest starting with capital of £10,000 in FTSE 250 stocks, and achieve 10.6% in annualised returns. And every year, I reinvest my dividends while adding £400 a month.

Clearly, over time, my portfolio should grow in size. And the longer I leave it, the larger the pot becomes. 

YearsPot size
5 years£48,420.77
15 years£223,925.00
25 years£728,143.06
35 years£2,176,745.52

If I have the ability to leave the funds to grow for 35 years, at the end of the period I would have more than £2m.

And from here, I start taking the passive income to fund my life. A dividend yield of 5% would furnish me with £105,000 a year. That’s a pretty impressive return on a monthly investment of £400.

Naturally, there are ways I can enhance the size of my portfolio further. For one, I could increase my monthly contributions in line with inflation.

If I increased my contributions by 5% each year, after 35 years, my pot would be worth a staggering £3.25m. That’s enough to generate more than £150,000 in passive income each year.

Managing risk

The risk profile of FTSE 250 stocks can be higher than those on the FTSE 100, but that’s why I have to pick carefully.

Tough economic conditions can adversely impact smaller stocks more than larger companies. This is because smaller companies typically have fewer resources at hand to weather challenging operating environments. 

We can observe this just by looking at the performance of the indexes over the past year. The FTSE 100 is up 3% — albeit aided by surging resource stocks — while the FTSE 250 is down 15%.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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