Total Stock Market vs S&P 500
Should You Buy a Total Stock Market Index Fund or an S&P 500 Index Fund?
Which is best, a total stock market index fund or an S&P 500 Index fund? Although both are very similar in style, there are subtle differences. For example, both funds invest in large US companies but total stock index funds typically have small-cap and mid-cap stocks. What are the advantages and disadvantages of each?
There are also some mistakes to avoid in the total stock market index vs S&P 500 index debate.
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."
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 but both 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.
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 4 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.
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.