You have several choices when it comes to building an investment portfolio that will, ideally, generate long-term wealth. You could load up on individual stocks and hope you choose the right ones. Or, you could rely on index funds.
Index funds are passively managed funds whose performance is tied to a specific benchmark. If you buy shares of an S&P 500 index fund, for example, the goal of that fund will be to do as well as the S&P itself.
Index funds are a popular option in 401(k) plans, but you can buy index funds outside of an employer-sponsored plan. Whether you should or not is a different story, so ask yourself these questions before making that call.
1. Do I know how to research stocks?
Some people have no idea what it means to thoroughly vet a stock. And while there are resources out there that could help you learn, if the idea of digging into companies' financials is daunting to you, then index funds may be a better fit.
Index funds don't require a lot of research. That's because you're not choosing one company over another -- you're simply identifying a market index to follow. And so if you don't trust yourself to choose solid companies for your portfolio, index funds may give you more peace of mind.
2. Do I have the time to research stocks?
It may be the case that you know what to look for in a stock -- solid management, good cash flow, reasonable levels of debt, and ample growth opportunities. But if your schedule is such that you're perpetually pressed for time, and you really don't have the patience to sit around researching stocks, then index funds may be a simpler, more efficient way for you to invest.
3. Is my goal to beat the market?
The main downside of investing in index funds is that they won't allow you to outperform the broad market, and so you'll need to make sure you're OK with that.
The reality is that even if you don't beat the market, you could still do quite well for yourself as an investor. The S&P 500, for example, delivered an average annual return of about 10.5% between 1957 and 2021. If you put $500 a month into S&P 500 index funds over the next 40 years and the index performs comparably, you could end up with a portfolio worth $3 million. That's not too shabby.
But do keep in mind that if you were to invest the same amount of money in individual stocks, you might end up with $3.5 million or $4 million at the end of that window. And so you'll need to decide what your ultimate wealth-building goals are.
What's the right choice?
Index funds take much of the guesswork out of investing, and they have the potential to deliver solid returns. But that doesn't ensure that they're the right investment for you. Before you make that call, consider the pros and cons involved.
At the same time, do recognize that you don't have to limit yourself to index funds versus individual stocks. If your portfolio ends up consisting of both, you might enjoy the best of both worlds as an investor.