When it comes to investing, you don't need to do extraordinary things to build an extraordinary amount of wealth. There's a common misconception that in order to achieve decent investment returns in the stock market, you need to know how to analyze stocks and construct a portfolio of individual stocks with your money. However, you might be surprised at how simple index fund investing can build wealth for your future.
With that in mind, let's take a look at how index investing works and how much wealth you could build by investing $5,000 per year (about $417 per month) in a simple portfolio of index funds.
What are index funds?
You can read my primer on index funds for a thorough overview, but here's the quick version.
An index fund is an investment vehicle that pools investors' money together and aims to track the performance of a certain benchmark index. As a basic example, an S&P 500 index fund would invest in all 500 companies that make up the index, in the correct proportions, to achieve the same overall investment performance as the S&P 500 over time.
The idea is that while returns of individual stocks can vary widely over time (and even go to zero in some cases), the overall stock market tends to do quite well over time. Legendary investor Warren Buffett -- who says that index funds are the best investment most people can make -- summed it up nicely when he called index investing as a "bet on American business."
Now, index funds aren't free, but their expenses can be remarkably low when compared with actively managed mutual funds. After all, because index funds simply track a benchmark index, there's no need to employ portfolio managers and analysts to choose stocks. Some of the top S&P 500 index funds have fees (known as expense ratios) of as little as 0.03% per year -- so you'd pay just $3 for every $10,000 you have invested.
Index funds are available as both mutual funds and exchange-traded funds, or ETFs. ETFs are usually the easier way to invest, as ETFs trade just like stocks and ETFs can be bought and sold whenever the market is open.
How much wealth could you build from $5,000 per year in index funds?
To be perfectly clear, stock market returns can vary significantly over short periods of time, and there's no guarantee that index funds based on benchmark stock market indices will go up over time. In fact, over the past 50 years, the S&P 500 has gained as much as 38% or lost as much as 37% in a single year. So, be prepared for short-term turbulence.
Having said that, when measured in decades, stock market returns are rather consistent. Since 1965, the average annualized return of the S&P 500 is 9.9%, and keep in mind that this includes the dot-com crash, the financial crisis of 2008-09, and the COVID-19 pandemic, just to name a few crash-inducing events.
Again, there's no guarantee that the exact same long-term returns will occur over the next few decades, but if you invest $5,000 per year in index funds at this rate of return, here's how your money could grow.
| Number of Years | Growth of $5,000 Per Year at 9.9% Returns |
|---|---|
| 5 | $30,465 |
| 10 | $79,306 |
| 15 | $157,608 |
| 20 | $283,143 |
| 30 | $807,057 |
| 40 | $2,153,652 |
Data source: Author's calculations. All figures are rounded to the nearest dollar.
How to get started
There are dozens -- if not hundreds -- of excellent low-cost index funds you could choose from, so there isn't one perfect way to get started. A core S&P 500 index fund can be a great backbone to your portfolio, and you can also branch out into other types of funds. Vanguard and Schwab are two examples of financial services companies that have many low-cost index fund options, and while you can buy their index ETFs and mutual funds through any online broker you choose, they both have some excellent information on their respective websites that can help you decide.
Alternatively, you could put your index fund investing on autopilot by choosing one of our top-rated robo-advisors. A robo advisor will invest your money in an automated portfolio of index funds that is appropriate for your age, risk tolerance, and investment goals.
Whichever way you choose, an index fund investor's best asset is time -- so there's no better time to get started than now.
