Should You Invest in the Total Stock Market or the S&P 500?

I’m a big fan of investing the simple way with low-cost index funds like those offered from Vanguard. Instead of trying to actively beat the market, you passively sit back and enjoy the handsome returns of the market.

But what’s the best way to invest in the stock market?

I often talk about either an S&P 500 index fund or a Total Stock Market Index fund, but what do these terms mean, and which is better?

Let’s break it down by comparing Vanguard’s S&P 500 index fund (VFIAX) and their Total Stock Market Index Fund (VTSAX).

But first, let’s dive deeper into the concept of a stock market index.

Where Do These Indexes Come From?

Put simply, stock market indexes exist because we need a way to track the performance of the stock market.

It’s easy to take for granted because of how easy it is now, but this used to be a huge problem. Can you imagine tracking the daily change of every stock in existence back in 1885?

It wasn’t a task they were up for. Instead, they tracked 30 stocks in an index called the Dow Jones Industrial Average. You’ve probably heard of it.

You might think that this is an inadequate representation of the market, and you’d be right, but not as right as you think you are. This is because of a phenomenon known as the Pareto Principle.

The Pareto Principle (or 80/20 rule) says that we can usually expect about 80% of our results to stem from just 20% of the causes. In the case of the stock market, this implies that you can get a good idea of what’s going on with this market as a whole just by looking at a few important stocks.

But 30 is still a really small number. And the Dow isn’t weighted by how big the companies are.

It’s pretty clear that we need a better index.

The S&P 500

The Standard and Poor’s index was originally started in 1926 and it tracked 90 stocks, triple the Dow. In 1957 it began tracking 500 of the largest American companies and turned into the familiar S&P 500.

Unlike the Dow, the S&P 500 is “capitalization weighted.” This is just a fancy way of saying that bigger companies like Apple count more than smaller ones like Under Armour (which is near the bottom of the list at the time I’m writing this). The relative size of a company is determined by market capitalization: The price of the stock multiplied by all the publicly traded shares.

There are over 3,900 publicly traded companies in America, so the S&P 500 represents well less than 20% of them. But because of the Pareto Principle, the 500 stocks of the S&P make up something like 75–85% of the market capitalization of the whole stock market.

Total Stock Market Indexes

In modern times, we don’t need to settle for tracking 30 or 90 stocks. We can effortlessly track them all. The world’s first Total Stock Market Index, The Wilshire 5000 was born in 1970.

Since then there are even more indexes that have emerged that seek to track the whole market.

These total stock market indexes include all the stocks of the S&P 500. And because the S&P stocks account for such a high percentage of the value of the total market, the total market and S&P are highly correlated.

Index Funds

You can’t directly invest in a stock market index, but you can invest in an index fund. An index fund is just a mutual fund that buys stocks in proportion to the index that it’s pegged to.

So if Amazon represents 3.8% of the market capitalization of the S&P 500 and you put $100 into an S&P 500 index fund like VFIAX, you’re essentially investing $3.80 into Amazon. This is because the fund takes your money and money from other investors, and devotes 3.8% of it to buying Amazon stock.

Instead of owning the stock directly, you share mutual ownership of a fund with other investors (hence “mutual fund”), and the fund owns stocks. Because the fund buys stocks to try to match and index, it’s called an index fund.

Comparing VFIAX and VTSAX

How They Are the Same

Both funds have identical $3,000 minimum investments and microscopic 0.04% expense ratios.

That low expense ratio is why index funds in general, and funds from Vanguard in particular, really shine. Even fees that seem small such as 1% expense ratios can silently eat your wealth if you aren’t careful. Vanguard does a great job keeping their fees low.

https://moneythesimpleway.com/the-tyranny-of-compounding-costs/

How They Are Different

The big difference is in the number of stocks that they own:

So if you invest in either one, you’ll be putting more money into Apple than any other company because Apple is currently the biggest company in the world. But if you invest in VTSAX, you’l be putting slightly less money into Apple because 15–25% of your money needs to get spread out over more than 3,000 additional stocks.

Which Index Has Performed Better Historically?

I think that Jack Bogle (the founder of Vanguard) provided an excellent answer to this question in The Little Book of Common Sense Investing:

Yes, there are variations over the interim periods: the S& P 500 was much the stronger from 1982 to 1990, when its annual return of 15.6 percent outpaced the Total Stock Market Index return of 14.0 percent. But since then, small- and mid- cap stocks have done a bit better, and the Total Stock Market Index return of 10.2 percent per year narrowly exceeded the 9.9 percent return of the S& P 500. But with a long- term correlation of 0.99 between the returns of the two indexes (1.00 is perfect correlation), there is little to choose between the two.

The Little Book of Common Sense Investing (Kindle Edition) pg. 41

Just to clarify some terminology:

• Large-cap = Large capitalization (big companies)
• Mid-cap = Middle capitalization (medium companies)
• Small-cap = Small capitalization (small companies)

Pretty much by definition, the S&P 500 is mad up of large-cap companies. A total market index is mostly large-cap stocks, but by definition includes all the mid-cap and small-cap stocks as well.

Which Will Perform Better in the Future?

There is no way of knowing the answer to this question. You can guess. You might even be right. But there’s no way to know.

If the roughly 3,500 companies that aren’t included in the S&P 500 outperform the S&P, the VTSAX will be the superior asset in the long term. If they return less than the S&P 500, you’d be better off with VFIAX.

Either way, they shouldn’t be that different. What happens to the S&P 500 is what happens to 75–85% of the whole stock market because the S&P is 75–85% of the whole stock market.

How Should You Decide?

Flip a coin.

I’m serious: Flip a coin.

If you prefer one to the other, great, go with your gut. If not, I like Ramit Sethi’s advice from his book I Will Teach You to be Rich: Just decide and don’t spend more than five minutes thinking about it.

Final Thoughts

VFIAX and VTSAX are both great index funds. They’re both perfect for those just getting started investing. They both have wonderfully low expense ratios.

Which you choose depends on whether you prefer the S&P 500 or the total stock market.

Personally, I prefer the total market, but most of my money is in an S&P fund. This is because my company’s 401k offers a great low-cost S&P 500 index fund, but doesn’t have a total stock market index fund. But I don’t mind. The S&P is good enough for me.

Ultimately, the two are 99% correlated. You don’t know which one will be better in the long run. The best strategy is to make a decision and go on with your life. You’re choosing between an “A” and an “A+” and there’s no way of knowing which is which.