It's one of the toughest questions investors must ask themselves over and over again: Do I accept higher risks for the bigger rewards that only individual stocks can offer, or do I seek the safety in numbers with mutual funds or exchange-traded funds, knowing that could crimp my overall return?
Plenty of people take the former route, and understandably so. Much of the financial-media machine makes it easy to fall in love with individual stocks by virtue of touting high-potential stock stories. ETFs and mutual funds, on the other hand, neither make for great news nor bring massive gains to the table.
In other words, funds are not only relatively boring but seemingly not the most productive path to wealth.
Don't be fooled, though. You can become a millionaire by investing in ETFs just as well as you can by owning individual stocks. In fact, you could do even better by limiting yourself to exchange-traded funds. The trick is simply leaving them alone long enough to let them simmer.
Time and consistency are the keys
What does it take to become a self-made millionaire? Not as much money as you might think. But it does require a fair amount of time and a massive amount of self-discipline. More specifically, an investor needs enough self-discipline to continue putting money into the market even when it's tough to do so (including when the market is tanking).
To illustrate this point, let's look at a hypothetical investor named Jill.
Jill is 30 years old, earning an average income of $36,000 per year. She knows a little about the market, including the fact it's the only long-term way to outgrow inflation. But she also knows she doesn't have the time or desire to regularly keep tabs on a portfolio. She decides to keep it simple by committing to regular purchases of the SPDR S&P 500 ETF Trust (SPY -0.48%), plugging her into the broad market's overall performance. She can scrape up an extra $4,000 per year to put toward her investment, but even though she expects to receive regular pay raises, new expenses like children and a mortgage probably won't allow for any additional investment dollars later in life. She'd like to retire at 65 with a million bucks in the bank. Can she get there?
Believe it or not, she can. Assuming an average market return of 9% for a 35-year stretch, Jill's annual investment of $4,000 should be worth roughly $940,000 by the time she turns 65. Investing the occasional bonus she gets at work would help get her over the seven-figure hump.
Surprised? Don't be. This amazing growth can be attributed more to compounding than Jill's total contributions of only $140,000. She's earning good money on money she's already earned from her investing efforts.
Had Jill been able to start at the age of 25, she could turn a more-modest annual investment of $3,000 in the ETF into $1.1 million by the time she's 65.
And that's just the sort of net return one can expect on the most basic of index-based exchange-traded funds. Investors could "juice" their bottom line by venturing out from the most notorious of market indexes and taking on positions in ETFs representing higher-growth areas of the stock market. For instance, the Technology Select Sector SPDR Fund (XLK -0.65%) has fared even better than the S&P 500 over the course of the past 20 years, while the iShares U.S. Consumer Discretionary ETF (IYC -0.71%) has more than doubled the overall market's return for the same time frame. If the U.S. Consumer Discretionary ETF continues to perform as it has, Jill's modest-but-steady investment regimen could turn her recurring investment into more than $2 million, were it limited to that particular fund.
The flip side: Waiting to do something -- anything -- can cost you big-time. Had Jill waited until she was 35 to start investing in the SPDR S&P 500 ETF Trust, not even an extra $1,000 in annual contributions would get her to the million-dollar mark. Allocating $5,000 per year for a 30-year span would only leave her with about $740,000 by the time she was ready to retire.
Picking stocks is tough to do well
The funny thing is, most investors are arguably better served by taking this much simpler ETF-based approach to investing.
According to data collected by Standard & Poor's, most actively-managed mutual funds underperform their benchmark indexes. For example, last year, only about 42% of mutual funds offered to investors in the United States outpaced the S&P 500. The other 58% trailed the broad market's return.
Think about that for a moment. Most full-time stock-picking professionals who are trained (and paid well) to at least keep up with the market don't actually do so.
And the success rate only worsens as you lengthen the time frame in question, negating the argument that the pandemic created incredibly unusual circumstances. For the past five years, only 27% of domestic funds beat the market. In the past decade, only 17% of actively-managed U.S. funds topped the S&P 500. At 20 years, the win rate falls even further.
What gives? The data ultimately points to one of the market's most overlooked yet most dangerous realities: The effort to beat the market often leads to the ill-advised decisions that cause even most professionals to underperform it. That's not to say it can't be done. It's just to point out that, statistically speaking, it's darn difficult for most folks to do.
Think results, not entertainment
But you just don't like funds? Or you love the idea of winning big on an individual stock so much that you just can't bring yourself to allocate the bulk of your capital to admittedly less-sexy investments like an ETF? Fair enough. A simple solution is allocating some of your portfolio to exchange-traded funds with multiyear holding periods, and using the rest to pick individual stocks.
Just for the sake of discussion, though, ask yourself this tough question: Is your stock-picking effort actually moving you toward your goal, or has it devolved into a form of entertainment? Exchange-traded funds aren't exciting, to be sure, but they sure do get the job done. The key is not waiting too long to get started.
Just something to think about.