Buying individual stocks can certainly be a smart way to go for investors with the time, knowledge, and desire to play an active role with their asset allocation. On the other hand, since most Americans don’t check all three of those boxes, there’s no need to buy individual stocks to build serious wealth over time.
In fact, you might be surprised at what you can potentially achieve with some basic index funds, steady contributions, and a few decades to let your investments grow.
3 Simple index funds to buy
There are literally hundreds of great, low-cost index funds available to investors, so these aren’t the only three that could become great wealth-building tools for you. And in full disclosure, in addition to a portfolio of individual stocks, I own five different index funds, including all three I’m about to discuss here.
Having said that, here are three great choices for investors who want to keep things simple.
First and foremost, a great choice is a low-cost S&P 500 index fund like the Vanguard S&P 500 ETF (NYSEMKT: VOO). This simply tracks the benchmark S&P 500 index, which is widely considered to be the best barometer of the U.S. stock market. Since 1965, the S&P has returned an average of 10.2% annualized, and with an expense ratio of just 0.03%, this ETF allows you to keep most of your gains. I’d even go so far as to say that if you were to only buy the S&P 500, you’d probably do just fine over the long run.
Having said that, I’d also add a small-cap index fund, such as the Vanguard Russell 2000 ETF (NASDAQ: VTWO). Small-cap stocks in general have higher growth potential over the long term compared with their larger counterparts, and there have been decade-long periods where small caps have handily outperformed large-cap stocks. For example, in the 2010s, the Russell 2000 outperformed the S&P 500 by about 50 percentage points. Plus, unlike the S&P 500, which is heavily weighted in favor of megacap tech companies, the Russell 2000 isn’t too dependent on the performance of any single stock.
A third index fund I’d add is the Vanguard Real Estate ETF (NYSEMKT: VNQ), which invests in real estate investment trusts, or REITs, and serves a couple of big purposes as part of an index fund portfolio. First, real estate tends to produce comparable long-term returns to the S&P 500, but with lower average volatility. Second, REITs tend to pay above-average dividends, so this can serve as a great income generator once you reach retirement age.
REITs also tend to not be terribly correlated with the rest of the stock market when it comes to short-term performance. For example, REITs often outperform when the rest of the stock market is doing poorly. So adding this index fund can help make your long-term performance a little smoother.
Doing the math
Here’s why these index funds can be such powerful wealth creators over time. First of all, they will absolutely have their ups and downs over time, but because you aren’t reliant on any particular company’s performance, the long-term direction of the value of your investment is likely to be positive.
Second, if you contribute $500 per month, evenly divided among these three index funds, that is $6,000 per year. A $6,000 annual investment compounded at a 10% annualized rate would grow to about $344,000 after 20 years and would surpass the million-dollar mark in just over 30 years. After 40 years, you’d be sitting on a $2.7 million nest egg. All from simply buying passive index funds and holding on to them forever.
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Matt Frankel has positions in Vanguard Real Estate ETF, Vanguard Russell 2000 ETF, and Vanguard S&P 500 ETF. The Motley Fool has positions in and recommends Vanguard Real Estate ETF and Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.
