Not only can you retire with just index funds, but you might be surprised at how much wealth you can build.
In full disclosure, I'm a big fan of investing in individual stocks. I own 48 of them in my portfolio. But that doesn't mean that you have to invest in individual stocks to build wealth in your retirement accounts.
In fact, the exact opposite is true. It is entirely possible to build a retirement portfolio entirely out of index funds, and to build a large retirement nest egg. Legendary investor Warren Buffett has actually said that investing in low-cost index funds is the best move for the majority of people, and says that "it is not necessary to do extraordinary things to get extraordinary results."
Here's a rundown of how effective a portfolio of index funds can be over long periods of time, as well as some tips to set yourself up for success.
Can you build a retirement nest egg with just index funds?
The short answer is a resounding yes.
Let's take a look at why this is. While past investment performance doesn't guarantee future results, the return of S&P 500 index funds has been about 9% to 10% annualized per year over long periods, depending on the exact timeframe you're looking at. Bond index funds have historically averaged about 4% to 5%. So, we'll say that a reasonable long-term expectation is for a portfolio of index funds to grow at a rate of 7% per year over your investing career.
We'll say that you set aside $6,500 per year in retirement accounts, the 2023 maximum IRA contribution, starting at age 25.
Based on this contribution rate, you would have contributed a total of $260,000 by the time you turn 65. But with a 7% compound growth rate, your money could be reasonably expected to grow to about $1.4 million. That's why it's absolutely possible to retire using just index funds. Now imagine if you had a 401(k) or other retirement plan in addition to an IRA.
Tips for index fund success
Index funds can allow you to put your retirement savings on auto pilot, but there are some steps you can take to set yourself on the right path.
Keep fees low
Index funds have investment fees, known as the expense ratio. These can vary significantly, even among index funds that essentially do the same thing. Vanguard and Schwab are two examples of firms that offer extremely inexpensive index funds, just to get you started.
Set an appropriate asset allocation
One good rule of thumb is to subtract your age from 110 to determine your ideal stock allocation. In other words, a 30-year-old should have 80% of their assets in stocks (or stock-based index funds) with the rest in fixed income, or bonds.
Contribute automatically
Timing the stock market is a losing battle, so the best way to set yourself up for strong returns over time is to contribute consistently over time. One great way is to automate your contributions and investments, which most online brokerages allow you to do. Try setting an automatic transfer each month, or on every payday.
Should you use index funds or buy individual stocks?
Like most personal finance topics, there's no one-size-fits-all answer to this question. The key thing to keep in mind is that if you have the time, knowledge, and desire to research and evaluate stock investments and create a diverse portfolio from individual stocks, it can be a good idea. If you don't, index funds are a completely solid way to create a retirement portfolio and can build wealth over time without the stress of relying on the success of individual companies.
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