“I want to invest in the market but I don’t know if I should start with an index fund or the S&P 500.”
What in the world did this person just say? And does it make sense? Want the answers to these questions? Keep reading.
Some of the terms in finance can be intimidating. I imagine this is by design. Let’s start with the basics.
The Market, S&P 500, Index, Fund.
The “market.” This can vary depending on context but generally, when people in the finance world mention the market, they are referring to the collection of all publicly traded companies, typically in the United States. What is a publicly traded company? It’s a company that you can buy or sell a share of. If you can’t buy or sell a share of it, it’s private. Easy example: Starbucks is public. The local coffee shop down the street is probably private. Generally speaking, if it’s a big company that you have heard of, it’s probably a publicly traded company. Even some big companies that you haven’t heard of are public. Amazon, Apple, Netflix. All publicly traded companies. Your neighbors dog walking company, your cousins plumbing business. Both private. Make sense? There are some, but not a lot, of big companies that are private. One such outlier is Chic-fil-a. It’s big but it’s private. You cannot buy a share of Chic-fil-a like you can buy a share of McDonald’s.
So, like we mentioned above, “the market” can vary by context. But it typically means: all of the stocks. Some companies are big and some are small, right? We call the size of a company an intimidating term called “market capitalization” or “market cap.” The bigger the company (in terms of total value), the higher the market cap. Ex: Apple has a higher market cap than Home Depot. How do I know that? I looked it up. And for this level of discussion, it just doesn’t matter. If you are looking for the easiest way to invest in “the market”, you’re going to buy all of them anyways. We’ll get to that. Another similar term for “the market” is the S&P 500. “I’ve heard of that but what is it?” It is a list, or “index”, of the 500 companies in the United States that have the highest market caps; the 500 biggest publicly traded companies. It’s literally just a list and what’s important is that you don’t have to worry about every company that is on that list. It’s just the 500 biggest companies. Wal-Mart, Apple, Target and 497 of their biggest friends. When you “invest in an S&P 500 index fund” you’re buying a small piece of all 500 companies. Whoever you buy it through (Vanguard, Fidelity, etc.) does all the math for you.
If you’re still with me, we can look further down the rabbit hole… What about the smaller companies? The 501st biggest company is not included in the S&P 500 index. Nor are the next several thousand companies. “The market” can also include all of these smaller companies. These are also publicly traded companies but, because they are smaller, they generally get less attention. These would NOT be in the S&P 500 but would fall into a “Total Stock Market Index.” For our purposes, the “market” can just mean, the S&P 500. It doesn’t include every publicly traded company, but it has all of the big ones. It’s a simplification, but it’s a common one.
Index fund? Index = list. Fund = pool of investor money. So, an index fund is just a pool of money that you contribute to and the fund manager (Vanguard, Fidelity, etc.) buys shares in that list of companies. The easiest example is an S&P 500 index fund. When you buy a share of this, you’re investing in all 500 of the biggest companies in the U.S. This is indiscriminate and requires no choices on your part. If a company is on the list, you’re buying it. If it’s not, you’re not. Important note: an S&P 500 index fund from Vanguard is essentially the same thing as an S&P 500 index fund from Fidelity, or any other brokerage house. Those in charge of these funds, or the “fund managers,” simply take your money and allocate it according to the list. Simple as that. The opposite of an index fund would be an “actively managed” mutual fund. These fund managers have a more difficult job. They do not just buy all 500 of the biggest companies. They try to outsmart everyone by only buying specific companies that they think will do well and they don’t buy others because they think they will do poorly. It’s important to note that it’s very difficult and typically rare for actively managed funds to beat “the market” or “the S&P 500.” They are also more expensive. Expensive? Every fund has a fee that they charge. They take it out of your balance every year and for index funds, it’s generally very low. Let’s say a quarter of a percent or less. So for every $1,000, you’d pay about $2.50 per year. Actively managed funds are generally much more expensive and can be well over 1% or higher. That extra percent can really matter in the long run due to the power of compounding. See this post if you’re curious how small amounts early on can result in big returns later:
https://bote.finance.blog/2019/11/25/compound-interest-and-the-rule-of-72/
So, to review… the market is all of the stocks. An index is a list of stocks. It could be 500 or it could be more, or even less. It’s just a list. The S&P 500 is just a specific list. It’s a list of the 500 biggest American companies. An index fund is something that you can buy and it will disperse your money according to that list, indiscriminately.
Back of the Envelope Finance 