If you're new to investing, you may be overwhelmed, and that's understandable. Investing in individual stocks isn't easy, and to do it well, it takes time and research. You need to learn about different industry and company drivers, take into account macroeconomic factors, and determine whether a stock is undervalued or overvalued.
On top of that, the market is full of landmines. A J.P. Morgan study found that between 1980 and 2020, more than 40% of stocks that became part of the Russell 3000 index experienced a "catastrophic price loss," which it defined as a 70% decline from which it never fully recovered.
The Russell 3000 Index is made up of 3,000 of the largest U.S. companies, so it is one of the broader market indexes. Meanwhile, about 40% of stocks in the index had negative returns, and about two-thirds of stocks underperformed.
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However, these cautionary statistics should not keep you from investing in the stock market. In fact, over the past decade, the benchmark S&P 500 index has generated an average annual return of 14.6%, as of the end of September.
So how does the S&P 500 perform so well when so many individual stocks struggle? The answer is actually quite simple: It rides its winners higher. The S&P 500 is a market capitalization (market cap) index, which means that the larger a company becomes by market cap (its shares outstanding multiplied by its share price), the bigger the part of the index it becomes.
J.P. Morgan found that about 10% of stocks become "megawinners" that have a 500% or more cumulative return compared to the Russell 3000 index. By letting these "megawinners" ride, the S&P 500 and other broad market cap-weighted indexes tend to perform well over time. It's very much a survival-of-the-fittest approach, but it works.
It's also the opposite strategy of what most professional investors employ. Most professional investors tend to pare their winners as they go up, and double down on their losers. This is probably why only 14% of actively managed funds have been able to outperform the S&P 500 over the past decade.
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Keep it simple
This is also why, for most investors, the single best strategy they can use is investing in an index exchange-traded fund (ETF) like the Vanguard S&P 500 ETF (VOO +0.55%). This is a low-cost ETF that mimics the performance of the S&P 500 index, which most professional investors fail to beat. And with an expense ratio of just 0.03%, the costs are minimal. In fact, after expenses, the difference between the S&P 500's annual performance and that of the Vanguard ETF is 14.64% compared to 14.6%.
While $1,000 is a great amount to start investing in with this ETF, it should just be a start. If you can dollar-cost average into the ETF over a long period of time, you can create long-term wealth, and the sooner you start, the larger your portfolio will grow. Dollar-cost averaging is about investing a set amount each month, regardless of whether the market is up or down, and is a proven long-term strategy.
For example, if you can start with $1,000 and invest an additional $500 a month over the next 30 years, your portfolio would grow to over $1.5 million with just a 12% average annual return. If you start at an even younger age and invest the same amount over 40 years, your portfolio would balloon to more than $4.9 million, with 95% of that being from gains.
So, while investing in individual stocks is tough, investing in one simple ETF using a basic dollar-cost averaging strategy can help set you up for life in retirement. And the sooner you start, the better off you'll be.
