Total Stock Market vs. S&P 500

Introduction

Investors seeking broad exposure to the U.S. stock market typically choose between two options: the S&P 500 index or a total market index. Over the long run, the difference between them is unimportant. Yet many investors still find themselves overanalyzing the choice. This article breaks down the key differences, saves you some research time, and explains which approach I prefer and why.

In a nutshell, index investing is a passive investment strategy that seeks to capture the average market return by owning index funds rather than attempting to beat the market through individual stock selection or active fund management. Index investors accept that consistently picking winning stocks over long periods is extremely difficult and are therefore content with earning the market return year after year—relying on the power of compounding, rather than outsized bets, to build wealth.

The approach is simple and effective, but it still requires one key decision: which vehicle to use to capture that market return: the total market or the S&P 500.

Before diving into the specifics of the total market and the S&P 500, it’s helpful to understand market capitalization. When I refer to the “size” of a company, I’m talking about its market capitalization (or market cap), which is calculated by multiplying the number of shares outstanding by the share price. Both the S&P 500 and the total market indexes weight their holdings based on market cap.

Overview

The S&P 500 is basically (but not exactly) the 500 largest companies in the United States. It is an index built by Standard & Poor’s (a company that provides indexes and credit ratings). The goal of the S&P 500 is to capture about 80% of the stock market’s total value, and the amount it captures can vary from 75%–85% at any given time. However, the index is not purely based on size. While all S&P 500 companies must meet a minimum size threshold, there are other criteria a company must meet for inclusion. Companies must also demonstrate financial viability by meeting profitability requirements. Even then, membership is not automatic. A committee ultimately selects the S&P 500 companies, aiming to maintain balanced representation across sectors of the U.S. economy. As a result, a company can meet all stated criteria and still be left out. This happened to Tesla for a period of time. Inclusion is ultimately at the discretion of the committee.

At one time, the S&P 500 served as a reasonable proxy for the overall U.S. stock market. Over time, however, it became possible to capture nearly 100% of the market’s total value through various total market indexes. While there is only one S&P 500, multiple total market indexes exist; in this post, I’m referring specifically to the Dow Jones U.S. Total Stock Market Index.

Inclusion in the total market index is largely mechanical: a company must be publicly traded and based in the United States. Although the total market index shares some criteria with the S&P 500—such as liquidity and investable weight factor—it does not impose minimum size or profitability requirements. As a result, the total market extends beyond the S&P 500 companies to include thousands of mid- and small-cap companies, totaling more than 3,800 holdings at the time of this writing.

Total Stock Market Pros

I prefer the broader exposure that a total market fund provides to mid- and small-cap companies, which have historically outperformed large-cap stocks over long periods of time. Owning smaller companies also allows you to capture the full growth of the next major success before it becomes widely known.

I also prefer the objective methodology used by total market indexes over the discretion used by the S&P 500. In today’s highly polarized and politicized environment, I’m uncomfortable relying on a committee’s judgment—particularly given the well-documented benefit a stock receives from inclusion in the S&P 500.

The additional holdings in a total market index naturally reduce concentration in the largest companies, shifting portfolio weight away from mega-caps. Large, popular companies are more susceptible to valuation-driven bubbles, and reducing concentration in them can lessen the long-term impact of a bubble unwinding by lowering exposure to extreme valuations (the total market held up better in the Lost Decade of 2000-2009 than the S&P 500).

Because total market indexes have no profitability requirements, they also allow investors to own companies that may be temporarily distressed but later recover and thrive. Finally, by owning the entire market, FOMO (fear of missing out) can be eliminated. There’s no need to guess which company will be the next big winner when you already own them all.

S&P 500 Pros

Although I personally prefer a total market fund, there are strong arguments in favor of the S&P 500. First, owning 500 companies already provides substantial diversification, and expanding to 3,800 companies might be over-diversification and may offer diminishing returns. In fact, research has shown that owning as few as 20 stocks can eliminate most company-specific (non-systematic) risk.

While I favor the objective, rules-based inclusion process of total market indexes, the S&P 500’s committee-driven approach—particularly its financial viability screening—can be viewed as a benefit, as it helps ensure that only profitable, established businesses are included. Finally, the S&P 500 has the endorsement of Warren Buffett, one of the most respected investors in history. Buffett has repeatedly recommended it and has even specified in his will that 90% of his heirs’ inheritance be invested in an S&P 500 index fund, with the remaining 10% allocated to short-term Treasury bonds.

Conclusion

I personally prefer the total stock market, but you’re unlikely to go wrong with either option. Because the S&P 500 represents roughly 80% of the total stock market, the two indexes have a 0.99 correlation—meaning their long-term returns are nearly identical.

Over shorter periods, one will outperform the other depending on which segment of the market is leading. When small-cap stocks outperform, as they did in the 2000s, the total stock market tends to have a slight edge. When large-cap stocks lead, as they did in the 2010s, the S&P 500 tends to come out ahead.

There is no reason to hold both in the same account. Choose the approach that aligns with your preferences and stay the course. Below are different ways you can invest in these indexes.

• Total Market ETFs: VTI, SCHB
• Total Market Mutual Funds: FSKAX (Fidelity), VTSAX (Vanguard), SWTSX (Schwab)
• S&P 500 ETFs: VOO, IVV, SPY
• S&P 500 Mutual Funds: FXAIX (Fidelity), VFIAX (Vanguard), SWPPX (Schwab)

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