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Can index funds make you a millionaire? The answer is yes, but there are caveats. With time and financial discipline, you can amass a seven-figure retirement account by way of index fund investing. Let’s cover everything you need to know below.
Understanding Index Funds
Index funds are pooled investment portfolios that replicate a financial market index. Because the index defines which assets are in the fund—rather than a team of researchers and fund managers—index funds are cost-efficient to operate. This benefits fund shareholders by way of a low expense ratio.
When the expense ratio is lower, more of the underlying investment returns flow through to shareholders. Many Fidelity index funds, Vanguard index funds and iShares index funds have low expense ratios.
Index funds come in many forms. You can find index funds that hold stocks, bonds or alternative assets, both individually and in combination. Some are broadly diversified, while others are highly focused.
Funds that track a major market index like the S&P 500 deliver market-level performance in a cost-efficient, convenient package. The alternative is owning each of the S&P 500 stocks individually, which would be cumbersome to manage.
Note that index funds can be mutual funds or exchange-traded funds (ETFs). For more information, see index funds vs. mutual funds.
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Why Are Index Funds A Popular Choice For Retirement?
Many retirement savers choose index funds because they are diversified, they deliver long-term appreciation and they’re suitable for novice investors.
Diversification
Index funds can hold hundreds to thousands of positions. They can provide equity exposure to every economic sector or bond exposure to the full range of maturities.
Achieving similar diversification with individual holdings is possible but inconvenient. You would have to buy far more shares, potentially paying fees on each trade, and then manage and rebalance those shares over time. Rebalancing is the process of adjusting your portfolio’s composition to a set target, such as 60% stocks and 40% bonds.
Long-Term Performance
The stock market’s long-term, inflation-adjusted annualized return is roughly 7%, as measured by the S&P 500, including dividends. To be clear, the stock market does not grow 7% every year. It can be down 20% in one year and up 20% in the next year. Historically over long timeframes, these ups and downs have averaged out to annual gain of about 7% after inflation.
A 7% return outperforms cash by a wide margin and real estate. Index funds that track the S&P 500 provide easy access to these market-level returns, albeit with a slight reduction for fund expenses.
Suitable For Novice Investors
Index fund investing does not require a long list of special skills. You do not need to know how to pick stocks or time the market. Mainly, you must know how to budget and follow a simple allocation strategy. Both skills are explained in more detail below.
The Power Of Compound Earnings
Compound earnings is an important concept for investors to understand because it expedites wealth creation. With that understanding, you can structure your retirement investing program properly to avoid return-limiting mistakes.
Compounding happens when earnings start generating returns of their own. Say you own a stock that appreciates 75% from $10 to $17.50. You now have an unrealized gain of $7.50. If the stock appreciates again, you earn on the original price of $10 and on the $7.50 gain. A second 75% boost to that stock therefore creates a bigger gain of $13.13. That is compounding in action.
The same dynamic happens when you reinvest dividends. Over time, the dividends you earn produce more dividends. As a result, your income potential rises without further investment.
To maximize compounding potential, follow these three habits whenever it makes sense:
- Hold stocks as long as possible, so unrealized gains will compound.
- Reinvest realized profits.
- Reinvest dividends.
How Much Should You Invest To Retire As A Millionaire?
The monthly investment required to amass a seven-figure retirement account is highly dependent on your timeline. A longer timeline has more compounding potential and, therefore, requires a lower total investment.
The examples below demonstrate the advantage of investing early and often. All three scenarios assume you are investing in a tax-deferred account with an average annual return of 7%. To reach $1 million under these conditions, you can:
- Invest $418 monthly for 40 years. The total investment is $200,640.
- Invest $883 monthly for 30 years. The total investment is $317,880.
- Invest $2,032 monthly for 20 years. The total investment is $487,680.
- Invest $6,032 monthly for 10 years. The total investment is $723,840.
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Investing Strategies To Consider
A primary appeal of index investing for retirement is that it can be done successfully by novice and experienced investors. By combining dollar-cost averaging, a targeted asset allocation and long holding periods, you can build wealth efficiently over time.
Dollar-Cost Averaging
Dollar-cost averaging is the practice of investing small amounts periodically rather than larger amounts less frequently. As an example, you might invest $50 monthly rather than $600 annually.
With smaller, more frequent trades, your average per-share cost on the fund is more likely to align with current market conditions. On the other hand, investing larger amounts less frequently raises your risk of buying just before a market crash. Doing so would immediately put you in a loss position. This isn’t critical if you plan to hold the fund indefinitely, but it might be stressful.
Dollar-cost averaging is also easier to budget and encourages you to make investing a habit rather than an occasional activity.
Asset Allocation
Asset allocation is the composition of your portfolio across different asset classes, such as stocks and bonds. Setting a target composition helps you manage risk and growth potential. For maximum growth, for example, you’d hold a high percentage of stocks—say 90%. For low volatility and capital preservation, you’d limit your stock holdings to 40% or less.
Once you set a target composition, you must maintain it by rebalancing. If you don’t rebalance, your stock exposure and overall risk will gradually increase over time. This is because stocks appreciate while bonds do not.
To rebalance, you can sell a portion of your over-exposed positions and use the proceeds to buy under-represented positions.
Long Holding Periods
Holding equity index funds indefinitely lowers risk and increases earnings potential. Stock prices can be unpredictable in short timeframes, but they have a solid history of growth over the long term. While history never guarantees future performance, it is an indicator of behavior. Two behaviors to note are:
- No stock market crash in history has been permanent. The stock market has always recovered and returned to growth.
- The S&P 500, a proxy for the overall market, has never lost value over timeframes of 20 years or more.
Long holding periods are associated with higher earnings because more time in the market provides more opportunity for compound growth.
Tax Considerations For Index Funds Investors
Equity and bond index funds are less tax-efficient than non-dividend-paying stocks. Equity index funds pay dividends and capital gains distributions, while bond index funds generate interest income. Stocks that don’t pay dividends only incur taxes when you sell them and realize capital gains.
You can, however, defer your tax liability by holding index funds within a tax-advantaged retirement account. You will not pay annual taxes on dividends, capital gains or interest income earned within a traditional 401(k) or IRA. Those taxes are deferred until you take qualified distributions in retirement. Additionally, gains and income earned within Roth accounts can be fully tax-free if you follow the distribution rules.
Well-Known Millionaires Who Recommend Index Funds
The simplicity of index fund investing as a path to wealth has won over some well-known investors, including Warren Buffett, John Bogle, David Swenson and Jeremy Schneider.
- Warren Buffett. Buffett is worth an estimated $143 billion, making him the world’s sixth-richest man. He runs the conglomerate Berkshire Hathaway and is known as “the Oracle of Omaha” for his investing prowess. Berkshire Hathaway owns small positions in S&P 500 index funds. Additionally, Buffett’s will specifies that money left to his wife will be invested in index funds.
- John “Jack” Bogle. Bogle founded the Vanguard Group and invented the index fund. In his book, The Little Book of Common Sense Investing, Bogle said, “Owning the stock market over the long term is a winner’s game, but attempting to beat the market is a loser’s game.” He also called the index fund an “unlikely hero for the typical investor.”
- David Swenson. Swenson was the chief investment officer at Yale University and author of the book Unconventional Success: A Fundamental Approach to Personal Investment. In his book, Swenson said, “When you look at the results on an after-fee, after-tax basis, over reasonably long periods of time, there’s almost no chance that you end up beating the index fund.”
- Jeremy Schneider. Schneider is the founder of Personal Finance Club. After selling his first company for $5 million, he retired at age 36. Schneider keeps his net worth growing—without a paycheck—by investing in index funds and living simply.
So, Can You Retire As A Millionaire With Index Funds?
Yes, you can retire as a millionaire with index funds—assuming you have time on your side and the discipline to stick to a plan. As shown by the four scenarios above, the monthly and total investment amounts required to reach a seven-figure account balance are far lower when the timeline is 30 years rather than 10.
Even if you don’t think you can invest enough to reach your goal, start investing now anyway. Funds invested today have more growth potential than funds invested tomorrow. Use that to your advantage. Trust that as you build wealth momentum, your million-dollar plan will take shape.
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