They're certainly not sexy. In fact, they're downright boring. That's the point, though: Index funds are designed to simply mirror the broad market's performance without actually beating it. Yawn.
The thing is, index funds are arguably the average investor's best bet when it comes to building a retirement nest egg. And yes, you can absolutely become a self-made millionaire using these ho-hum holdings. Here's proof, and a clear reason you'd want to use them over individual stocks anyway.
Crunching the numbers
If you're unfamiliar, an index fund is simply a basket of stocks that hold the same equities in the same proportion that make up popular benchmarks like the S&P 500 (^GSPC -1.20%) or the Dow Jones Industrial Average (^DJI -0.65%). These baskets are bought and sold as a single unit, rather than forcing you to buy and sell all 500 stocks that make up the S&P 500 or the 30 names that comprise the Dow. Their real upside, therefore, is the ease with which they offer you instant diversification.
But what about performance? Don't investors have to constantly trade the market's hottest stocks to build a seven-figure stash from scratch? Nope. Not even close.
This graphic speaks volumes. Assuming the S&P 500's average annual return of 10% and an annual contribution of $5,000 into an IRA (individual retirement account) for 35 consecutive years -- the typical length of a career these days -- leaves you with a nest egg of nearly $1.5 million at the end of that time frame.
Data source: Calculator.net. Chart by author.
There are three important footnotes regarding the image's visual message you'll want to embrace.
First, while the S&P 500's average annual return may be 10%, its actual returns from one year to the next can be all over the map. Some years are better, and some are worse. One out of every four years is negative! The average return will get you to millionaire status, but it won't happen in such a straight line.
Second, this hypothetical growth took shape within a tax-deferred IRA, which doesn't incur taxable liabilities while it grows. Were its value down in a conventional taxable account, at least some of this growth would be taxed on the way up. In that case, you'd end the 35-year stretch with less than $1.5 million. Still, even with a regular brokerage account, you'd eclipse the million-dollar mark by putting $5,000 worth of capital to work in an index fund over the course of three and a half decades.
And third, notice how the vast majority of this portfolio's growth took shape in just the last few years of the accumulation period.
The question remains, however: Are index funds the best way to retire a millionaire?
My answer is simple: yes.
The odds favor this approach anyway
It's not a message that the financial media delivers very well. Rather, the markets-reporting business tends to focus on individual, publicly traded companies, subtly suggesting everyone should be picking stocks; the idea of index-based investing is rarely touted.
Most of the major institutions, funds, research outfits, and even brokers know, however, that index funds are a better bet than individual stocks for most investors.
Perhaps Standard & Poor's number-crunching on the matter is most telling. Its semi-annual SPIVA (S&P Indices versus Active) scorecards compare the returns of all actively managed mutual funds offered to U.S. investors to their most relevant benchmark index.
Despite having plenty of training and access to all sorts of data and tools the typical investor doesn't have, these SPIVA reports indicate that most actively managed funds reliably underperform passively managed funds (or index funds). In 2022, for instance, Standard & Poor's says 51% of large-cap funds managed in the United States underperformed the S&P 500. And that was a better-than-average year, with most performances made relatively stronger by the broad market's weakness; many managers did well simply by sitting on the sidelines.
And stretching out the comparison time frames to give fund managers more time to outperform the market doesn't help. Indeed, if anything, it hurts. Standard & Poor's most recent SPIVA report also indicates that for the past five years, over 86% of domestic large-cap funds failed to keep pace with the S&P 500. For the 10- and 15-year time frames, that figure is ratcheted up to 91% and 93%, respectively.
If the vast majority of the pros can't do it, it's unlikely the average amateur will be able to out-trade the S&P 500's long-term returns either. Simply keeping pace with the broad market benchmark's performance means you're likely doing better than most.
At least make index funds your portfolio's foundation
But you just can't get excited about index funds? Maybe it simply doesn't feel right to not at least take a swing at beating the market.
That's OK. You can have the best of both worlds. That is to say, set aside a portion of your portfolio for picking individual stocks, while committing the rest to index funds like the Vanguard 500 Index Fund (VFIAX -1.44%) or the SPDR S&P 500 ETF Trust (SPY -1.25%).
Given the odds and the challenge of just finding time to keep tabs on individual stocks, though, most investors would be best served by making index funds the core of their holdings. They're easier to buy, and much easier to hold on to when the market gets a bit rocky. After all, stocks as a whole have a great long-term track record of bouncing back from pullbacks.
James Brumley has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.
