Picking individual stocks can be a lot of fun (and potentially rewarding). However, for most of us, investing in a simple index fund makes the most sense — at least for the bulk of our retirement fund. That's because most investors are typically better off not trying to beat the market, but instead just riding its rising tide for a few decades.
The good news is, even this passive approach to investing is likely to allow the average income earner to become a self-made millionaire by the time he or she decides to retire.
Time is the biggest factor
Not every new investor believes it's possible to amass a seven-figure fortune starting from scratch — but it is. The key is using all the time afforded to you and then compounding your returns. Compounding means making more money on the earnings you've generated from the cash you've already put to work in the market. And it doesn't take as much money as you might think to get this financial snowball rolling.
Let's take a hypothetical 25-year-old named Ted as an example. Ted has landed a job as an apprentice HVAC technician earning a relatively typical $34,000 per year. He has to use most of that for living expenses, but he's committed to tucking away 10% of his yearly salary — $3,400 — toward retirement. Assuming he allocates that amount to an S&P 500 (SNPINDEX: ^GSPC) index fund like the Vanguard 500 Index Fund (NASDAQMUTFUND: VFINX) every single year for the next 40 years, at an average annual return rate of 9%, Ted will be able to quit working at the age of 65 with around $1.1 million in his portfolio, thanks to the magic of compounding interest.
A quick note to point out here that different funds calculate compounding at different rates. For the purposes of these examples, the compounding has been calculated on an annual basis. If it were done on a daily basis, the total at age 65 would be closer to $1.4 million. So, clearly, how the compounding occurs can make a big difference over time.
In a second hypothetical example, Kelly didn't get started with a professional career as soon as Ted did, choosing to earn a postgraduate degree. But it was worth the wait for her. At the age of 30, she's now earning $50,000 per year. Like Ted, she's willing and able to put 10% of her annual income to work in the market, or $5,000 per year. Using the same conservative estimate of an average return of only 9% per year, an index-based investment will get Kelly to the $1 million in savings mark at the age of 65 as well.
Then there's Robert. Robert's lack of focus in his youth lingered into his mid-30s, and he didn't get serious about saving or investing until he turned 35. But he landed a great job as an app tester with a major internet powerhouse willing to pay him $60,000 per year. Like Ted and Kelly, Robert's also going to invest a tenth of his annual income for retirement. Though he's only going to work for 30 years, his annual contribution of $6,000 per year earning about 9% per year (again, on average) will leave him with more than $800,000 when he's 65. If he consistently uses part of his yearly bonus to beef up that annual contribution, Robert could also get over the $1 million mark.
Ted (9% return on
$3,500 saved annually)
Kelly (9% return on
$5,000 saved annually)
Robert (9% return on
$6,000 saved annually)
But what if you could squeeze more out of the market than 9% per year? Sure, if your earnings and savings profile looks like one of the three above, cranking the average annual return of 9% up to just 11% would push you well over $1 million mark in all three cases. The nickels and dimes add up.
If that's your plan, though, be careful. Consistently beating the market no matter how much time and money you're able to commit to the effort is difficult.
Standard & Poor's fleshes out this reality with its regular reports regarding the mutual fund industry's overall performance. It's always eye-opening — and even a little shocking — that most mutual funds — which are sometimes advertised as ways to beat the market — fail to even keep pace with benchmarks like the S&P 500 (let alone beat them). In 2020, a little more than 57% of domestic stock funds underperformed the S&P 500. Large-cap funds were worse, with 60% of them lagging the S&P 500 large-cap benchmark.
And it wasn't just a raucous, complicated year holding these fund managers back. The track record gets worse when looking at longer time frames. For the past 10 years, 83% of U.S. mutual funds didn't keep up with their most relevant index benchmark, and for the past 20 years, an incredible 94% of mutual funds lagged the S&P 500. Mid-cap and small-cap funds didn't fare any better.
What gives? Aren't these fund managers supposed to be some of the best and brightest? It's evidence of what may be the market's most frustrating truth: The harder you try to beat the market, the more difficult it becomes to do so. If the pros can't do it, the odds of amateurs consistently doing it are a bit too low as well.
Don't misread the message. There's nothing inherently wrong with owning individual stocks. Most of the mutual fund managers that didn't even keep up with the broad market's performance lagged not because they owned individual stocks, but most likely because they tend to swap them out at the worst possible time. You can get so much more out of the market when you're willing to just leave your portfolio alone and let it simmer for years on end.
That being said, if you just want to play the odds and own an S&P 500 index fund, that's still certainly a valid path to becoming a millionaire retiree.
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