In recent years, a lot of investor money has been flowing into index funds. Investors seem to love the low-cost nature of index fund investing, as well as the diversification and ease that comes with them.
This certainly makes sense, but is it possible to make serious money by simply investing in index funds? The answer will surprise you. Here's a look at what would have happened if you had put money into an S&P 500 index fund in 1980 (38 years ago) and had simply reinvested your dividends along the way.
What is an S&P 500 index fund?
An S&P 500 index fund is an investment vehicle, either in mutual fund or exchange-traded fund (ETF) form, that invests in the 500 stocks that comprise the S&P 500 index, in market cap-weighted proportions.
While fees vary, these tend to be extremely cheap ways to invest. As of this writing, S&P 500 ETFs can be found with expense ratios as low as 0.03%. This means that for every $10,000 you have invested, fees will only be $3 per year.
Warren Buffett's favorite investment
Billionaire investor Warren Buffett has said that an S&P 500 index fund is the best investment most Americans can make. In fact, he's said that he wants his own wife's money invested in such a fund after he's gone. This might seem a bit surprising, as Buffett is well-known for his stock-picking ability.
First of all, he isn't necessarily saying that it's a bad idea to buy individual stocks if and only if you have the time, knowledge, and desire to do it right. However, most Americans don't.
Essentially, Buffett feels that an investment in an S&P 500 index fund is a bet on American business, which has historically been a very good one. Over the long run, the S&P 500 has generated total returns of about 10% annualized.
And since S&P 500 index funds generally have minimal fees, you get to keep the vast majority of the returns. In a nutshell, an S&P 500 index fund guarantees that you'll do as well as the market over time, which has historically been quite good.
Good years and bad
To be clear, Buffett is a fan of S&P 500 index funds as a long-term investment. In other words, if you'll need the money you're investing within a few years, you're better off looking elsewhere, such as a five-year CD or bonds.
The reason for this is that the S&P 500, just like individual stocks, can be quite volatile over shorter periods of time. Over the past 50 years, the index has gained 30% or more in nine separate years, but has also lost as much as 37% in a single year, even after factoring in dividends. However, over long periods of time -- say, 20 years or more -- the S&P 500 has never been a bad choice.
How much would $10,000 in 1980 be worth today?
To illustrate this, let's say that you had invested $10,000 in a low-cost S&P 500 index fund in 1980. Since Jan. 1, 1980, the S&P 500 index has generated a total return of approximately 7,670% as of this writing. This translates to a 12.1% annualized rate of return.
Assuming an expense ratio of 0.1% on your index fund (you can find even lower costs now), this means that a $10,000 investment would have turned into just over $760,000 as of Feb. 1, 2018.
This is why Warren Buffett loves cheap index funds as an investment for the majority of Americans. Sure, you wouldn't have beaten the market, but you would have been guaranteed to do just as well as the market. An S&P 500 index fund would have allowed any investor to turn $10,000 into more than three-quarters of a million dollars in less than four decades -- with the bare minimum of effort and expense.