Why Does the Total Stock Market Typically Beat the S&P 500?

The S&P 500 is a stock market index which tracks the overall performance of the 500 largest American companies (based on market capitalization). This is a great metric which can be used to understand the swings of the overall market and is also the model for some of the most popular index funds.

An index fund is a fund with a portfolio which mimics that of a specific market index (for a more in-depth explanation see here). In the case of the S&P 500, the fund would be comprised of the companies represented in this index. So, instead of investing in a single company, you could diversify and invest in 500.

The 500 largest companies in the US seem like a perfect investment opportunity, right? They all have proven track records, and many are deeply engrained in American society so they should make the ideal investment. . . the only problem is, that they aren’t.

There is an incredibly simple method to consistently beat the S&P 500’s returns and the secret is another index fund. Index funds which incorporate more companies into their portfolio actually have higher returns than the 500 over the long run.

The reason behind these superior returns is attributed to the number of companies the portfolio consists of and which specific companies are chosen. While companies in the S&P 500 have a proven track record and already dominate large portions of their respective industries, they lack the growth potential enjoyed by their smaller counterparts. It is much easier for a company making $10 million in profits annually to double than for another company already making $1 billion.

This growth is also seen in stock value. A company trading at $10 a share only needs to increase by $10 dollars to earn a 100% return on investment. A company like Amazon, which trades near $1,000 per share, requires a significantly larger dollar amount to accomplish the same return.

Not everyone needs to know the ins and outs of the stock market to be a successful investor. While previous results by no means indicate future performance, it can certainly help in making informed decisions. There is no reason why any person should invest their money into an S&P 500 index fund which will be beaten. . . and yet it still happens daily.

The S&P 500 receives a significant amount of media attention which is why many people invest in related index funds. These funds are in no way shape or form a poor investment, but why settle for good returns when another fund exists that can beat it? So, drop the S&P 500 index from your portfolio and look for a total market index.

Learn more here: https://www.forbes.com/sites/robertberger/2017/06/01/total-u-s-stock-market-vs-the-sp-500-index-an-investors-guide/#184581d02fd0

About Declan Peloso

Declan is a second year Economics and Business student, focusing on finance at the University of Puget Sound

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