S&P 500 vs. Total Stock Market

This article compares the S&P 500 with the Total Stock Market. The two indices are very similar but contain important differences. Is there an advantage to owning a Total Stock Market fund instead of the S&P 500? Or is it the other way around? After reading this article you will have a solid understanding of these similar yet different indices.

Who Cares?

Before launching into a detailed discussion lets pause for a moment and ask ourselves an important question: Who cares? The unfortunate answer to this question is "Not many." The next question we ask is: Who should care? The answer to this question is "Still not many, but a few more than last time." The astute reader has probably deduced that there a few people who should care about the differences between the S&P 500 and the Total Stock Market but do not. Read on to find out if you are one of those people.

Introduction

The S&P 500 and the Total Stock Market are both market-capitalization weighted indices. The S&P 500 represents the 500 largest publicly traded companies in the United States, accounting for a few other factors such as liquidity and industry grouping. The Wilshire 5000 and MSCI US Broad Market Index are indices that contain all active publicly traded U.S. stocks which at current count numbers more than 6,700¹. There is little difference between Total Stock Market indices and this article will not distinguish between them.

The S&P 500 and Total Stock Market indices can be purchased through a variety of mutual funds or ETFs. I recommend purchasing the Vanguard funds VFINX for the S&P 500 and VTSMX for the Total Stock Market.

Similarities

Before we delve into the details, lets look at a picture:

Diagram 1: Comparison of S&P 500 vs. Total Stock Market

Diagram 1 shows a comparison of the S&P 500 and the Total Stock Market. The comparison spans roughly 10 years from June 20, 1996 to January 22, 2006. Over this time period $10,000 invested in the Total Stock Market would have grown into $22,119.01 at a respectable rate of 8.67% per year. $10,000 invested in the S&P 500 would grow into $21,180.82 at a rate of 8.14% per year. The Total Stock Market returned nearly $1,000 more than the S&P 500 (or 0.53% more per year).

Does this chart alone mean the Total Stock Market is the superior index? Certainly not. How would the results differ if our time period ended in June 2000 instead of January 2006? According to Diagram 1 the S&P 500 performed better than the Total Stock Market until June 2000 at which point the trend reversed. Therefore if our time period ended in June 2000 the S&P 500 would have performed better than the Total Stock Market. This shows that it is dangerous to measure performance using a small amount of data. Ten years is not enough.

If you have difficulty understanding which index is performing better, think about the chart as if it were a horse race. The distance between the lines can also represent the distance between two horses. Until June 2000 the S&P 500 horse pulled ahead of the Total Stock Market horse meaning it was running fastest, or performing the best. After June 2000 the Total Stock Market horse closed the gap between the S&P 500 horse, meaning it was running faster than the S&P 500 horse even though it was still losing the race until April 2005.

The only valid conclusion we can draw from Diagram 1 is that the S&P 500 performance closely matched the Total Stock Market performance from June 20, 1996 to January 22, 2006. In reality, the S&P 500 will always perform similarly to the Total Stock Market. This is true because the two indices are nearly identical: 80% of the Total Stock Market ingredients are the S&P 500. To illustrate, observe the top five holdings of each index in Diagram 2:

We see that both indices have the same top 5 holdings in roughly the same amounts. For example, consider $1,000,000 invested in both indices. This would purchase $36,100 of ExxonMobil in the S&P 500. In the Total Stock Market it would purchase $28,700 of ExxonMobil which is about 80% of $36,100.

If both indices hold roughly the same stocks then we would expect them to perform roughly the same. Thankfully this is true and the logical order of the universe is not breaking down². If 80% of the Total Stock Market is the S&P 500, what's in the other 20%?

Differences

The Total Stock Market is comprised of many more companies than the S&P 500. It is more than ten times larger, in fact. How is it possible that their performance is so similar? The answer is that both indices are market-capitalization weighted. This means that each stock in the index is weighted proportionally to its market cap. Lets run through an example:

The current market cap of the entire US stock market is 13.8 trillion dollars. The current market cap of General Electric (GE) is 348.3 billion dollars. 348.3 billion divided by 13.8 trillion is 0.0252, which can also be written as 2.52%. This means that GE represents 2.52% of the total US stock market. Looking at Diagram 2 we notice that GE composes 2.52% of the Total Stock Market index as well. This is not a coincidence. Lets take a look at a different company, Somanetics (SMTS). Somanetics weighs in at a market cap of 274.9 million dollars which is less than one thousandth the size of GE. This represents 0.0019% of the total US stock market. Therefore we would expect Somanetics to compose 0.0019% of a Total Stock Market mutual fund such as VTSMX³.

Now we should understand how the Total Stock Market can contain so many stocks and still perform similarly to the S&P 500: The additional stocks in the Total Stock Market have a small impact on performance because they make up a small portion of the index. In our example the price movements of GE are over one thousand times more important than the movement of Somanetics. As of January 24, 2006 the Total Stock Market is composed as follows:

Since small and medium cap stocks represent a smaller percentage of the Total Stock Market, one might think they are not important. This is far from true. Owning small and medium cap stocks diversify the Total Stock Market holdings and may increase performance in the long run. Lets take a look at another diagram:

Diagram 4: Total Stock Market components: NAESX (small) VIMSX (medium) VFINX (large)

Diagram 4 shows the performance of small, medium and large cap stocks from May 28, 1998 to January 23, 2006. Small cap is red, medium cap is blue and large cap is green. We see that large cap stocks win the race until about June 2000 when they begin to lose value rather quickly. At this point in history many people became quite unhappy as their net worth began to approach zero. People whose portfolios consisted mainly of large cap stocks were the most unhappy of the bunch, although not quite as unhappy as those who owned technology stocks. If you remember the beginning of this article (I know, it's long. I'm sorry.) then you remember that the Total Stock Market began to perform better than the S&P 500 at about this same time. What was previously a mystery is now solved. The Total Stock Market performed better than the S&P 500 because it contains medium and small cap stocks which have recently outperformed the large cap stocks in the S&P 500. Since the Total Stock Market index is diversified in small and medium cap stocks it was less affected the poor performance of the S&P 500. The other side of this coin is that it will also be less affected by strong performance of the S&P 500. No free lunch here.

Continue reading Page 2 for the conclusion.