6 min read
In The Bogleheads’ Guide to the Three-Fund Portfolio, Taylor Larimore gives several reasons for why index funds are better investment vehicles than individual stocks for most investors:
1. Most individual stocks underperform index funds
“Unlike mutual funds, individual stocks can plunge to zero. On the 50th birthday of the S&P 500 Index, only 86 of the original 500 companies still remained, showing it is possible to turn a large fortune into a small fortune with individual stocks. On the other hand, it is unheard of for a registered mutual fund to go to zero.”
2. Low costs
“To give you an idea of the impact of costs, consider this: If stocks gain an average of 6% annually during the next 30 years, someone who invested $25,000 with a 1% yearly fee will forego more than $35,000 in gains because of the fee – more than the original investment!“
3. Maximum diversification (lower risk)
“The Lehman Brothers bankruptcy in 2008 is an example of the need for diversification. Lehman Brother was founded in 1850, and in 2000 it was the fourth largest investment bank in the United States. In the 2008 Bear Market, Lehman Brothers went bankrupt, causing thousands of their employees and individual investors who owned Lehman Brothers shares to lose all, or part, of their retirement benefits and life savings.
Vanguard Total Stock Market Index Fund investors also owned Lehman Brothers shares in their fund, but because their fund was diversified with thousands of other stocks, Total Stock Market fund shareholders were little affected by the bankruptcy. This is another advantage for total market index funds: Because all your stocks and bonds are wrapped into one fund, you don’t see the carnage that unnerves other investors, causing them to worry and sell at exactly the wrong time (i.e., during Bear Markets).”
Larimore goes on to explain that investors can achieve the benefits of stock index-fund investing through owning just one fund: VTSAX or VTI, the Vanguard Total Stock Market Index Fund or ETF equivalent. By owning this one index fund, you hold a piece of ownership in all 3,600+ publicly traded stocks in the U.S.
However, there exists another stock index fund that Warren Buffett recommends for the average investor: a low-cost S&P 500 index fund.
So, if you want to keep investing as simple as possible and only invest in one stock index fund, should it be a total stock market index fund or a S&P 500 index fund?
Related: No matter which fund you choose to invest in, I highly recommend using Personal Capital to track your investments. It’s a completely free tool that makes it easy to track the value of your investments and ensures that you’re paying the lowest fees possible.
Comparing VOO vs. VTI
To keep things simple, let’s compare two well-known ETFs (exchange traded funds) offered by Vanguard:
VOO – Vanguard S&P 500 ETF
VTI – Vanguard Total Stock Market ETF
First, let’s get a brief overview of both funds:
|Fund Type||Exchange Traded Fund (ETF)||Exchange Traded Fund (ETF)|
|Minimum Investment||The price of one share||The price of one share|
|Number of Stocks||3,607||508|
We can see that both funds have the same expense ratio of 0.03%. That is, if you invest $10,000 into either fund you will pay $3 each year in management expenses.
We can also see that the minimum investment for both ETFs is simply the current price of one share. So, at the time of this writing you’d need a minimum of $265 to buy one share of VOO and $147 to buy one share of VTI.
The dividend yield for VOO (2.07%) is slightly higher than that of VTI (1.97%), which could be a small consideration for investors who prefer index funds with higher yields.
The biggest difference between these two funds is their composition: VOO holds 508 stocks while VTI holds a whopping 3,607.
So, let’s take a look at this difference in composition and see if it impacts performance at all.
VOO vs. VTI: Differences in Composition
As the name suggests, the S&P 500 is composed of the largest 500 publicly traded companies in the U.S. There are 508 stocks in the index, though, because some companies have more than one “class” of stock. For example, Berkshire Hathaway has class A and class B shares. Thus, VOO is composed of the 508 largest stocks in the U.S.
Conversely, VTI is composed of every single publicly traded stock in the U.S. At the time of this writing, that amounts to 3,607 individual stocks.
This means that VOO is just a subset of VTI. That is, VTI includes all 508 stocks that are in VOO as well as an additional 3,099 smaller stocks.
These 3,099 smaller stocks are known as mid-cap and small-cap stocks since their market capitalizations are smaller than the large-cap stocks in the S&P 500 index fund.
It’s important to note that since VTI is market-cap weighted, the 3,099 smaller stocks actually only compose a small portion of the total fund. In fact, about 75% of VTI is composed of stocks in the S&P 500.
In addition, most people don’t realize just how large the largest stocks in the S&P 500 are relative to the other stocks in the index. For example, at the time of this writing the Vanguard fund page for VTI says that the top 10 holdings account for nearly one-fifth of the entire fund.
To further understand just how massive the largest stocks are relative to all other stocks, I made an interactive visualization that lets you see how large the biggest stocks are relative to the smallest stocks in terms of market cap.
Using this visualization tool, you can see that the largest 5 stocks in the S&P 500 have a market cap equal to the smallest 282 stocks:
And the largest 10 stocks in the S&P 500 have a market cap equal to the smallest 342 stocks:
These numbers are a bit mind-blowing.
This illustrates why the additional 3,099 stocks in VTI that are not in VOO don’t make a huge difference in terms of composition because these stocks are just so small relative to the biggest stocks in the S&P 500.
This also explains why both VOO and VTI are classified as “large-cap” index funds. VOO contains only large-cap stocks and since VTI is market-cap weighted, it’s composed of about 75% large-cap stocks.
Nevertheless, the two funds do have slightly different compositions so let’s see if this difference impacts the annual returns.
VOO vs. VTI: Differences in Performance
The following table from Paul Merriman shows the annualized returns for the S&P 500 vs. the total stock market for each decade dating from 1930 to 2013:
|S&P 500 Index||-0.1||9.2||19.4||7.8||5.9||17.5||18.2||-0.9||9.7|
|Total Stock Market||-0.2||9.6||18.2||8.3||6.1||16.7||18.0||-0.3||9.7|
As you can see, the two indices offer extremely similar returns. In some decades, the S&P 500 outperforms. In other decades, the total stock market outperforms. Incredibly, from 1930 to 2013 the two indices both offered 9.7% annual returns (assuming dividends reinvested).
These results shouldn’t be surprising. The S&P 500 and the total stock market have a very similar composition, thus their performance over the years has been very similar.
VOO vs. VTI: Which Should You Invest in?
I personally prefer to invest in VTI since it offers slightly more diversification with mid-cap and small-cap stocks. However, if you’re even debating whether you should invest in VOO or VTI, that’s a good indication that you have your financial life in order and either investment should perform fine over the long haul.
One last thing to mention is that sometimes you don’t have the option to invest in a total stock market index fund with an account like a 401(k), which means you will be forced to choose a S&P 500 index fund. This was the case in one of my 401(k) accounts with my old employer, so I simply invested in a S&P 500 index fund.
In most cases, you’ll find that a S&P 500 index fund and a total stock market index fund have similar expense ratios and that these two types of funds have the lowest expense ratios of any fund you can invest in. This proves to be a win-win situation. You get maximum diversification for minimum cost.
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