The first Friday of May marks National Space Day. And let's just say this year has been a little out-of-this-world for investors. We've seen the wild ups and downs of GameStop (GME +4.00%) and AMC Entertainment (AMC +3.46%). Tesla (TSLA +2.40%) CEO Elon Musk vowed on Twitter to "put a literal Dogecoin on the literal moon."
In times like these, investing in passively managed exchange-traded funds, or ETFs, can seem a bit dull. But boring can be a beautiful thing when you're building long-term wealth. Here's how ETFs can launch your savings far beyond the stratosphere.
Image source: Getty Images.
How ETFs can make your savings soar
Let's acknowledge that investing in ETFs isn't going to make your net worth skyrocket tomorrow. ETFs are a basket of securities that are bought and sold on exchanges, just like regular stocks. Although there are a handful of ETFs that are actively managed — Cathie Wood's ARK Invest ETFs, for example — most ETFs are passively managed, which means they don't have a human manager choosing the investments. Instead, they seek to track the performance of a benchmark index as closely as possible.
But over time, simply achieving average stock market returns is enough to reach the moon. Take the returns of the S&P 500 index: In the past 40 years, the index has produced average annualized returns of over 11%, assuming dividend reinvestment. That might not sound impressive, given that triple-digit returns on individual stocks suddenly became more common following the March 2020 stock market crash.
It's true that individual stocks have more potential to deliver eye-popping returns, especially in a short period of time. But your odds of losing money are also much greater. In exchange for those potential returns, you assume the greater risk that your investment will take a supersonic skydive back to Earth.
But let's look at what would have happened had you made a $10,000 investment in the SPDR S&P 500 ETF Trust (SPY +1.46%), an S&P 500 index fund that's by far the largest ETF, with more than $363 billion in assets under management. Your $10,000 would have grown to over $101,000 in 25 years — and that's assuming you never added a dime. If you invested an additional $200 a month, you'd have about $327,000 at the end of 25 years — assuming roughly the same average annual return.
SPY Total Return Level data by YCharts
Of course, you don't have to stick with ETFs that track the S&P 500 or the overall stock market. You can use ETFs to invest in virtually any segment of the market. For example, you could buy ETFs that invest exclusively in small-cap stocks or a specific stock market sector.
Should you invest your savings in ETFs?
There are risks with any investment, including ETFs. It's highly unlikely that you'd lose everything since you're investing across many different companies. But in a prolonged downturn, an ETF's value will temporarily drop with the rest of the market.
That's why before you invest, you need a safety net. Try to save three to six months' worth of expenses in an emergency fund first. You don't want to have to sell your ETFs while they're down if you're hit with a big expense once the market has just tanked.
As you shoot for the moon and the stars, consider a Roth IRA if you qualify. Let's face it: Until you can literally take your savings to the moon, you can bet that the IRS will want its share of those astronomical returns. With a Roth IRA, you'll contribute with money you've already paid taxes on, but that money will compound and be all yours tax-free in retirement.
You may not reach the moon overnight. But with time and patience, ETFs can deliver returns that are truly out of this world.
