Index Funds Are Not Ideal For Early Retirement

In the world of money, the catchphrase of the day is “passive income.”

If you want to stick it to the man and be able to spend your days playing video games or watching TikTok videos, you need to have a money machine that works while you’re playing. You see it being peddled all over the internet, social media, and YouTube by so-called experts/gurus. And these snake oil salesmen are making a fortune targeting the lazy, not the ambitious.

Every online guru is touting passive income as the key to Easy Street, and they all seem to have the bulletproof “system” for achieving your dreams. For just three easy payments of $29 each – less than the cost of taking your significant other out for dinner – you can finally create the type of passive income that will help you achieve your dreams.

Let’s get something straight here. These people are marketers, not investors, and they have nothing to offer you in the way of how to allocate your portfolio. Instead, what they’re marketing is nothing more than a glorified pyramid scheme where you make money by recruiting other suckers and getting a percentage of the income generated from recruiting people downstream and so on.

What these gurus are doing is twisting what the ultra-wealthy say about passive income. And they’re using it to scam people out of money.

Here’s what the ultra-wealthy like Warren Buffett has to say about passive income:

“If you don’t find a way to make money while you sleep, you will work until you die.”

“Never depend on a single income. Invest in creating a second source.”  -Warren Buffett

These online gurus aren’t wrong. Passive income is essential to creating, building, and maintaining wealth. You’re just not going to find it in an $87 online course.

If your goal is to retire early or achieve financial independence, you will need to create one or more passive income streams. Unfortunately, most “passive income” strategies are ineffective at creating the type of wealth necessary to retire early.

A byproduct of the rise in popularity of “passive income” strategies has been the rise in popularity of index funds. And just like those online courses promising you a steady stream of “passive income” checks in the mail, index funds are equally ineffective as a strategy for retiring early.

Here’s why:

For review, index funds are traded on the stock market that invests in a mix of stocks using an “indexing” investment strategy. The most popular index funds invest in an underlying benchmark index like the S&P 500. The S&P 500 is widely accepted as a reliable index for tracking the stock market’s average performance.

Therefore, if you invest in an S&P 500 index fund like SPY (SPDR S&P 500 ETF TRUST), you should achieve average stock market returns. For example, if the S&P 500 returns 4% over a year, your return from an investment in SPY should be identical.

Here’s the problem with index funds:

Although the S&P 500 has averaged an annual return of 10% since 1928, there have been stretches of protracted bear markets where the market has underperformed. If you had started your investment in an index fund at the beginning of one of those periods, you would have made little in the way of returns or even lost money.  If your timing is off, an index fund will not only prevent you from retiring early it may even extend your retirement target.

Here’s what I’m talking about:

If you had started investing in 2000 in an S&P 500 index fund, you would have experienced two of the worst bear markets in history, the dot-com bubble in the early 2000s and the real estate bust of 2007.

Here are the S&P 500 returns from 2000-2010:

2010 = 15.06%

2009 = 26.46%

2008 = -37.00%

2007 = 5.49%

2006 = 15.79%

2005 = 4.91%

2004 = 10.88%

2003 = 28.68%

2002 = -22.1%

2001 = -11.89%

2000 = -9.1%

Average = 2.47%

Considering the average annual inflation of 3%, your 10-year return from an index fund starting in 2000 would have been negative. Investing in an index fund at the wrong time can be disastrous. Who’s to say another bear market is not around the corner? And with accelerating inflation, a market downturn can be a real possibility.

What are the alternatives?

Yes, passive income is important. No, index funds are not the way. In other words, they are not the right strategy for generating the type of passive income needed to retire early.

So, what type of passive income should you target?

The type that ultra-wealthy investors and successful institutional investors like university endowments have been targeting for years:

  • Commercial Real Estate (CRE).
  • Cash-Flowing Private Companies.

Why CRE and private companies?

Without going into full detail, ultra-wealthy investors target CRE and private companies because they offer passive income streams. These are ideal for reinvesting to compound wealth with underlying values that grow over time to provide multiple avenues of returns – all insulated from the volatility of Wall Street that index funds are susceptible to.

Cash flow, appreciation, and not to mention the significant tax benefits associated with passive real estate and business investing along with the opportunity to leverage the expertise of true “experts,” are all reasons the ultra-wealthy target these assets to generate the type of hands-free passive income ideal for building wealth uncorrelated to the broader markets.