If you are not familiar with the stock market, then building wealth can be an intimidating prospect. People often spend a lot of time trying to identify the next stock or asset that will break out, hoping to make a profit. But more often than not, an investor is better off sticking to the basics.
One of the most followed investors in history is Warren Buffett. The Oracle of Omaha has become an icon for investors with his simple strategy. While he owns stock in many different businesses across a variety of sectors, he complements these positions with a passive approach.
One of Buffett's core holdings in his Berkshire Hathaway portfolio is the Vanguard 500 Index Fund (VOO 1.00%). This exchange-traded fund (ETF) provides investors with exposure to the most influential companies in each market sector and is meant to mimic the overall performance of the S&P 500.
Let's break down how and why owning this broad basket of stocks can be a lucrative investment over a long time span.
What makes the S&P 500 so good for any investor
Unless you spend time analyzing businesses and management teams, choosing individual stocks can be a daunting exercise. While individual stocks might break out at any moment, owning index funds that track the broader markets can actually be a much better investment over time.
Index funds take many different forms. Some focus exclusively on one sector, such as technology, energy, or healthcare. And wealth managers like Cathie Wood tend to own less-mature businesses in emerging industries -- presenting a unique risk-reward dichotomy.
What makes the S&P 500 different is that by investing across a large cohort of sectors and companies of all sizes, investors quickly gain a high level of diversification.
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Don't underestimate the power of compounding
Individual stocks trade with different volatility levels on a yearly basis. While Buffett has made a career out of investing in different companies, he also holds on to his positions for decades. This methodology helps mitigate overly pronounced market sentiment in any given year.
Perhaps more important is that by holding over a long period, Buffett enjoys the power of compounding. Investors should realize, however, that choosing investments that consistently outperform the broader market is incredibly hard. Even the most prolific money managers have made their share of mistakes.
When it comes to investing in the S&P 500, factors such as dividends and inflation need to be accounted for. Inflation rates change on a monthly basis, and dividend payouts can be hard to predict. But over a long time, the S&P 500 has averaged a compound annual growth rate of almost 7% when accounting for inflation and the reinvestment of dividends.
Although this doesn't sound like a lot, imagine choosing individual stocks that return almost 7% every year for several decades. When you take this into consideration, it becomes more clear that investing just a couple of hundred dollars each month could result in hundreds of thousands of dollars over time.
And to boot, you do not need to take any time to study individual companies or stocks because the positions and weightings in the index fund will change based on market dynamics.
Is now a good time to invest in the S&P 500?
The chart above illustrates the total return of the S&P 500 over the last 30 years. The basic takeaway is that the broader market has risen over time, underscoring its resiliency following challenging economic periods.
But the more subtle key here is that choosing the specific correct time to invest in the market has often been an exercise in false precision. It's far more important to simply get started and spend time in the market, rather than trying to time the right moment.
Forming a disciplined approach to saving and allocating some capital each month to the broader market can help you build generational wealth over time.
While Warren Buffett is known for making generous charitable donations, his biggest act of charity might be sharing his template for how he approaches investing. If one of your resolutions this year is to start investing, the Vanguard 500 Index Fund is a terrific place to start.
