This post will discuss a decision that classic index investors have to make but is mostly insignificant in the long run. That decision is whether to invest in the total stock market (TSM) or S&P 500. As insignificant as it is, if you analyze your investments and are the type to give them serious thought, you will likely find yourself going down the rabbit hole of overanalyzing this decision at some point (or multiple points). This post will shed light on the differences to hopefully save you some research time, as well as tell you which I prefer and why.
In a nutshell, index investing is a passive investment strategy that seeks to capture the average market return through index funds rather than trying to beat the market by picking individual stocks or using fund managers. The index investor acknowledges that it’s too hard to consistently pick the right stocks over a long period of time, and therefore is okay with achieving the average market return year after year—relying on the power of compounding to make them wealthy rather than seeking large returns. Sounds simple (and it is), but you do have to decide which vehicle you want to use to capture the market return: TSM or S&P 500.
One thing to understand before moving into the specifics of the TSM and the S&P 500 is market capitalization. When I refer to the size of companies, I’m referring to the company’s market capitalization (AKA market cap). Market capitalization is the number of shares a company has multiplied by the share price (this is the market value of the company). Both the S&P 500 and the TSM weight their holdings according to their market cap.
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. All the companies in the S&P 500 have to meet a minimum size requirement, but there are other criteria a company must meet to be included. A company must be financially viable by meeting certain profitability requirements. A committee selects the S&P 500 companies, and they try to maintain a balance from the various sectors of the U.S. economy. Therefore, a company can meet the size and profitability requirements, but still be left out. This happened to Tesla for a while. Beyond the defined criteria, selection is at the discretion of the committee.
The S&P 500 was at one time the best proxy for the entire stock market. As time went on, it became possible to capture closer to 100% of the stock market’s total value through various “total stock market” indexes. While there’s only one S&P 500, there are several TSM indexes. In this post, I will be referring to the Dow Jones U.S. Total Stock Market Index. For a company to be included in the TSM index, they pretty much just have to exist and be a U.S. company. There are a few common criteria between the TSM and the S&P 500 (such as liquidity and investable weight factor), but there is no minimum size requirement and no financial viability requirement for the TSM. As a result, the TSM index stretches beyond the S&P 500 companies to include many mid-cap and small-cap companies and has more than 3,800 holdings at the time of this writing.
I like the exposure that the TSM provides to mid-cap and small-cap companies as they have historically outperformed large-cap companies over long periods of time. Holding small companies also allows you to capture the full growth of the next big company that none of us have heard of yet. I prefer the objective method of including stocks that the TSM deploys over the discretion used in the S&P 500. Given today’s overly political and extremely polarized environment (and the corruptible nature of man), I don’t trust a committee’s discretion—especially considering that a stock benefits from being included in the S&P 500. Since the TSM has over 3,800 companies, portfolio weight is shifted slightly away from the largest companies (see images below). I believe (without any data to support) that the large, popular companies are more susceptible to bubbles, so shifting weight away from them should lessen the pain of a bursting bubble. Having no profitability requirements makes it possible to own the stock of a down and out business that turns things around and soars. Lastly, by owning all companies, FOMO (fear of missing out) can be eliminated.
Although I prefer the TSM, here are what I see as the pros to the S&P 500. First, owning 500 companies is enough diversification, and 3,800 companies is probably over-diversification. In fact, one study showed that owning 20 companies pretty much eliminates all unique, non-systematic risks of a stock. Although I prefer the objective stock inclusion method, having a committee that screens stocks for financial viability can be seen as a good thing because it ensures only quality businesses are included. Lastly, Warren Buffett, who is one of the wisest investors in history, recommends the S&P 500 regularly. He even has it in his will that 90% of his heirs’ inheritance is to be invested in the S&P 500 (the other 10% in short-term treasury bonds).
So, there you have it. I prefer the total stock market over the S&P 500, but you will not go wrong with either. Given that the S&P 500 makes up roughly 80% of the TSM, the two are about 99% correlated, meaning their returns are almost identical over long periods of time. During different time periods, one will do slightly better than the other, and this will come down to whether large companies or small companies perform best during that time period. If small companies outperform (as they did in the 2000s), then the TSM will slightly outperform. If large companies outperform (as they did in the 2010s), then the S&P 500 will slightly outperform. There is no reason to hold both in the same account. Choose your preference and ride that one to wealth. Below are different ways you can invest in these indexes.
- Total Stock Market ETF: VTI
- Total Stock Market Mutual Funds: FSKAX (Fidelity), VTSAX (Vanguard)
- S&P 500 ETF: VOO
- S&P 500 Mutual Funds: FXAIX (Fidelity), VFIAX (Vanguard)
Bryant Quick 