Why is total market recommended over S&P 500?

[CrankAddict]

Hi Everyone!

I'm brand spankin' new here so forgive the newb questions.  I have tried searching to answer this but everywhere I look people just state it as a given that a Vanguard Total Stock Market fund is superior to a Vanguard S&P 500 fund, even if only marginally.  The extra diversification is the only thing that I have seen cited as a reason for this belief.  What I don't understand then is why when I look at 1-year, 3-year and 5-year the S&P fund outperforms the total stock fund at every interval.  I even found an article quoting Bogle himself as acknowledging that from 1928 - 2010 the S&P outperformed the total market slightly (granted there wasn't always 500 companies to make it a direct apples to apples with today).  But even in that article, he still seems to prefer the total market, again without specifying anything concrete.  To me, as somebody who knows so little about the market, it seems like there will always be winners and losers at any given time.  And that by definition a fund which tracks 'everything' will partially cancel out its gains with losses.  The notion of a fund built around only the 'best' X companies wouldn't seem to have that downside.

But I must be missing something huge in my analysis given the prevalence of the total market recommendations I come across, including from MMM himself.  Please help me get past the stubble stage on this mustache!

[Interest Compound]

You aren't missing anything. We have more historical data for the "S&P500", so people usually quote those numbers. Note, the S&P500 in it's current form (largest 500 companies) wasn't created until 1957. Before then it was only 90 stocks, and before then (created in 1923) it was even less. Yet we have data going back to 1871 for the "S&P500" :-P

In short, total market is recommended, because it holds ~3700 companies, instead of 500. It's more diversified. That's pretty much it.

[Ursus Major]

To me, as somebody who knows so little about the market, it seems like there will always be winners and losers at any given time.  And that by definition a fund which tracks 'everything' will partially cancel out its gains with losses.  The notion of a fund built around only the 'best' X companies wouldn't seem to have that downside.

Yes, a fund that tracks everything will have both outperformers and underperformers, that's the concept of passive investing. The notion that the S&P500 contains the "best" 500 companies is misleading though, it contains the 500 largest. And they are usually added, when they're already on the upswing (and pricy) and removed, when they're already on the decline (and cheap).

So there are some inherent problems with just holding an S&P500 fund as well. To me it makes sense to hold a total stock market fund, if you go with passive investing.

[WerKater]

The notion of a fund built around only the 'best' X companies wouldn't seem to have that downside.

That is correct. But how will you know in advance which will be the best X companies in the future?

[Telecaster]

Those are noob questions, but they are good noob questions.  Your thought process is exactly right.

Here's the answer:  The S&P 500 is large cap, that is, large companies.  That's great!  Because a slice of the largest American companies is a good thing to own.  But sometimes--and sometimes can mean a decade or so--small caps will out perform large caps.  And the converse is true.  And they tend to work oppositely. When small caps are surging, large caps are lagging, and vice versa.  So it is a little better to own the whole market instead of just the biggest part. 

Now, if I only owned the S&P 500 I would sleep like a baby.  But having the other parts of the market work for me makes me sleep even better.

[mathjak107]

a total market fund is barely going to show much difference from an s&p 500 . in fact the s&p 500 can have it's entire index moved by just the 50 top holdings .

when spreads are in the 5-6%  range between mid caps ,small caps and the s&p500  the difference between a total market fund and the s&p is around  1% at best .

if you think about it the 50 top holdings in the s&p 500 can move all 4950 other stocks .

to really take advantage of the rest of the market you really need an s&p500 fund and an extended market fund , then season to taste .

for the last few years with few exceptions mid caps and small caps were running at a pace 5-6% higher then the s&p 500 . vti was up about a 1% difference from just the s&p 500 . more typically the difference between spy vs vti  is a fraction of 1%

[beastykato]

Many of the best minds in the world/finance say you just need the S&P500.  I just hold the S&P500.  Either is fine, but don't sweat it, the extra diversification provided by total market isn't nearly worth as much as the companies already within the fund.  1 Because of the law of diminishing returns (at what point to you stop adding more to be more and more diversified?) and 2. because those companies comprise the majority of the total market anyway.

[CrankAddict]

Thanks for all the responses!

I would like to do some more long term comparisons on the total vs 500 but the Vanguard total doesn't even look to be 10 years old.  Is there a comparable total fund which goes back 20+ years so that I could analyze a little further?  I definitely understand the diversification point you guys are making, I'm just struggling to find real world data to prove to myself that the theory prevails in practice.  I've struck out for the last 16 years, always using an adviser and always feeling like I'm getting nowhere.  I made the call this morning to liquidate everything and I'm moving it all to a Vanguard account.  I'm 42 now, so I think the door is officially closed on retiring by age 40 lol.  Just need to make sure that I play it as smart as I can going forward...

[tonysemail]

S&P500 and TSM are closely enough correlated that I feel comfortable using them as tax loss harvesting partners.
I'm happy to hold either one of them long term.

And welcome to the forums :)

[CrankAddict]

Thank you!  I'm definitely going to have to investigate the tax side of all of this as "tax loss harvesting partner" sounds like a random collection of words to me haha

[tonysemail]

rest assured, you're not missing much.
that is really the last 1% of incremental things that you can optimize.
if you've committed to indexing and have the discipline to follow through, then you will capture 90% of the gains.

[k9]

They are so close to each other that you should just buy the one with the smallest fees.

[seattlecyclone]

Look at this view that compares the two back to the year 2000. The total market fund has outperformed the S&P 500 fund in that time period. One other thing to notice is just how well correlated the two funds are.

The important thing to note is that the S&P 500 makes up roughly 80% of your total market fund. The other 20% is small/mid-cap companies. Sometimes these companies outperform the larger companies in the S&P 500. Sometimes they don't. Because the S&P 500 is such a large fraction of the total market fund you won't usually find much difference in performance between the two over a given time period. I personally prefer the total market because it's slightly more diversified, but you really can't go wrong with either.

[mathjak107]

the best way is always an s&p 500 fund and an extended market fund . that lets you get as little or as much of an effect as you like from the various market segments

[CrankAddict]

Look at this view that compares the two back to the year 2000. The total market fund has outperformed the S&P 500 fund in that time period. One other thing to notice is just how well correlated the two funds are.

The important thing to note is that the S&P 500 makes up roughly 80% of your total market fund. The other 20% is small/mid-cap companies. Sometimes these companies outperform the larger companies in the S&P 500. Sometimes they don't. Because the S&P 500 is such a large fraction of the total market fund you won't usually find much difference in performance between the two over a given time period. I personally prefer the total market because it's slightly more diversified, but you really can't go wrong with either.

Thanks for that.  What I notice is that they've been pretty neck-and-neck for the last 5 years with the 500 slightly up in most cases.  But the 5 years prior to that the total had a clear edge.  So the question in my mind becomes, is there a good reason why they would be tracking closer to each other now than they were 10 years ago?  And if so the distinction between the two is probably less critical than it was previously.  Or is this more the nature of an increasing market and if the next 5 years go down could we potentially see the total more significantly outperform the 500 again?  All hypothetical and in some ways unanswerable, just interesting to ponder.

[seattlecyclone]

the best way is always an s&p 500 fund and an extended market fund . that lets you get as little or as much of an effect as you like from the various market segments

Why would you prefer that over a total market fund? The total market fund is literally the same thing as buying S&P 500 and extended market in an 80/20 ratio, but you don't have to do the work to keep them in balance.

[mathjak107]

read the above posts and you will see why . unless you do it that way the difference  even when midcaps and small caps are 5-6% ahead of the s&p500 will be close . hardly a difference at all most of the time  . far better to season to taste in my opinion to capture more of the spread  .

[Jack]

There is a school of thought that believes "tilting" your portfolio towards small-cap stocks (and sometimes value stocks) may increase returns. The S&P 500 (compared to the total stock market) is tilted in the opposite direction, so some avoid it in favor of TSM because of that. Others buy the S&P 500 fund, but buy extra small-cap funds (beyond their market capitalization weighting).

Either way, as the disclaimer on one of the links I'm about to post says, "tilting is not recommended for new investors, as it intentionally deviates from investing in the total market."

So read these just for learning's sake, then promptly ignore them and buy only one fund (either S&P 500 or TSM; doesn't matter which):

https://www.bogleheads.org/wiki/FAQ_small_cap_funds#What_does_.22tilting.22_to_small_mean_and_how_much_should_I_tilt.3F

https://www.bogleheads.org/wiki/Value_tilting_-_stock

http://www.obliviousinvestor.com/overweighting-small-cap-and-value-stocks/

Then maybe revisit the issue in a few months/years/decades when you have more experience.

[LLCoolDave]

There is a school of thought that believes "tilting" your portfolio towards small-cap stocks (and sometimes value stocks) may increase returns. The S&P 500 (compared to the total stock market) is tilted in the opposite direction, so some avoid it in favor of TSM because of that. Others buy the S&P 500 fund, but buy extra small-cap funds (beyond their market capitalization weighting).

Either way, as the disclaimer on one of the links I'm about to post says, "tilting is not recommended for new investors, as it intentionally deviates from investing in the total market."

So read these just for learning's sake, then promptly ignore them and buy only one fund (either S&P 500 or TSM; doesn't matter which):

https://www.bogleheads.org/wiki/FAQ_small_cap_funds#What_does_.22tilting.22_to_small_mean_and_how_much_should_I_tilt.3F

https://www.bogleheads.org/wiki/Value_tilting_-_stock

http://www.obliviousinvestor.com/overweighting-small-cap-and-value-stocks/

Then maybe revisit the issue in a few months/years/decades when you have more experience.

+1

[Grog]

The s&p 500 is mostly, but not only cap weighted. The s&p committee decide which stocks belongs so is only like 95% passive. TSM is truly passive and looks only at cap weight. Or so is my understanding

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[Radagast]

VTSMX is the Vanguard total stock market fund that goes back to 1992, so use that one for backtesting. In general you can go back farther using investor shares instead of admiral shares.