Stock market investors can create a passive income starting with relatively modest amounts and investing for the long term. It’s possible to set up an automated investment process that is simple to understand and that has a high probability of success over the long run. However, returns are never certain. So, as an investor I try to mitigate risks by diversifying my investments.
History shows that the long-run average annual return on the S&P 500 index is around 10%. This is despite several wars, the great depression of the 1920s, and the 2008 global financial crisis. Although future returns are not guaranteed, the long history of the S&P 500 can provide some guidance to past returns.
Start early for a bigger passive income
By investing £300 a month in an index tracker or diversified fund, it’s possible to build a substantial pot with enough time. The key is to start investing early. The earlier an investor starts, the more time investments have to compound.
For example, a 25 year-old investor who invests £300 per month in an S&P 500 index tracker for 30 years could build a pot of £678,000. This assumes a long-run average annual return of 10%. In the investment management industry, a widely used annual withdrawal rate is 4%. This is an estimation of how much an investor could withdraw without running out of money. So, in this example, the investor could receive a passive income of £27,000 per year.
This method of investing can provide a passive income for this investor by the age of 55. Now, if the investor starts investing 10 years later, at the age of 35 instead, the total investment pot could grow to £228,000. Again, this assumes an average return of 10%. This is not guaranteed and the total investment could be lower if the average return was lower. At a 4% withdrawal rate, this smaller pot would provide the investor a much lower passive income of £9,120.
The lesson from this example is to start investing as early as possible. It could significantly boost your passive income in later years.
Regular investments can smooth volatility
At times of crisis, investors have been known to panic. The 2020 Covid-19 crash is a recent example of investor panic and uncertainty. In February and March 2020, the S&P 500 index fell by approximately 35% from peak to trough.
At the time, there was much uncertainty about the effects of the coronavirus on the economy and companies. Such moments can be excellent opportunities to buy cheaper stocks. Of course, there’s a risk that cheap stocks can decline further. So, instead of trying to time the market, I’d set up a regular monthly investment plan. As the old investment adage goes: “Time in the market beats timing the market”. Trying to time the market can be a costly mistake for many investors, in my opinion. Instead, I think greater passive income can be achieved by holding good quality stocks for a long time.
An alternative to investing in the S&P 500 index is to choose a good quality global fund or investment trust. I particularly like Fundsmith Equity fund. It is a concentrated and global fund focused on long-term investing in high-quality companies.
Harshil Patel owns units in Fundsmith Equity Fund. The Motley Fool UK has no position in any of the shares mentioned. 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.