Total Stock Market vs S&P 500
Should You Buy a Total Stock Market Index Fund or an S&P 500 Index Fund?
Although the Total Stock Market Index and the S&P 500 Index are both are very similar in their total makeup and respective performance histories, there are subtle differences between the two indices. For example, both primarily consist of large-cap U.S. stocks but the total stock market includes small- and mid-cap stocks, whereas the S&P 500 Index only consists of large-cap stocks.
Since the two indexes are not exactly interchangeable, it is wise to compare and contrast the similarities and differences before investing.
The Total Stock Market is Not 'Total' Diversification
Where investors can get confused and/or make mistakes, is that many total stock market index funds use the Wilshire 5000 Index or the Russell 3000 Index as the benchmark or, as Morningstar labels it, the "best-fit index." However both of the "total stock market" indices are either mostly or completely comprised of large capitalization stocks, which makes them have a high correlation (R-squared) to the S&P 500 Index.
When you invest in total stock market index funds, you're not always getting a complete representation of the entire stock market. Therefore, the descriptor, "total stock market index," can be misleading. Both the Wilshire 5000 Index and the Russell 3000 Index cover a broad range of stocks.
In simpler terms, a total stock market fund does not really invest in the total stock market in a literal sense. A better descriptor would be "broad large-cap stock index." Many investors make the mistake of buying a total stock market fund thinking that they have a diversified mix of large-cap stocks, mid-cap stocks and small-cap stocks in one fund. This is not true.
Choosing an Index to Build a Diversified Portfolio
An investor can better capture the total stock market, assuming they want to build a diversified portfolio, by purchasing mutual funds that separately represent various market segments. For example, an investor may invest in four or more funds, each representing different fund categories, such as large-cap stock, small-cap stock, foreign stock, and fixed income (bonds).
For the large-cap stock portion, an investor would be wise to use a true large-cap index, such as one of the best S&P 500 Index funds, and build around it with other fund types.
In summary, a total stock market fund does not capture the total stock market; it captures a majority of the large-cap stock market with extremely small representation of other segments, such as mid-cap and small-cap stocks. Therefore it's average market cap is large-cap, which is why it performs similarly to and S&P 500 index fund.
Investors wanting to capture a full representation of the U.S. stock market may choose to allocate the stock portion of their portfolio to three separate index funds -- 1) an S&P 500 Index fund, 2) an S&P mid-cap 400 fund, and 3) a Russell 2000 Index funds (for small-cap exposure). This would create a more complete representation of the "total stock index" than a "total stock market index" fund.'
Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.