Diversifying Your S&P 500 Investments: Is It Worthwhile?

The S&P 500 is a stock market index that tracks the 500 largest companies in the U.S. by market capitalization. While you can't invest directly in the index, you can gain exposure to the S&P 500 by investing in individual stocks of S&P 500 companies or through index funds or exchange-traded funds (ETFs) that follow the index. Investing in the S&P 500 offers broad market exposure and diversification at a low cost, making it an attractive option for investors. So, should you invest in two different S&P 500 funds? Let's explore this question further.

S&P 500 index funds vs individual stocks

S&P 500 index funds are a type of investment that tracks the S&P 500 index itself. In other words, it includes the same stocks and mirrors its performance over time. Some popular examples include the Vanguard S&P 500 ETF, iShares Core S&P 500 ETF, and SPDR S&P 500 ETF Trust.

Investing in the S&P 500 through index funds is a relatively effortless way to grow your savings over time. It is also generally safer during periods of volatility. While your investments will likely take a hit in the short term during downturns, the S&P 500 has a long history of recovering from crashes, bear markets, and recessions.

On the other hand, the biggest disadvantages of S&P 500 index funds are that they cannot be customized, and they can only earn average returns. When you invest in an S&P 500 index fund, you have no choice over which stocks to include. Additionally, because S&P 500 index funds track the market, it is impossible for them to beat it.

Individual stocks, on the other hand, can help maximize your earnings and give you full control over your portfolio. However, investing in individual stocks is more time-consuming and requires you to thoroughly research every stock you buy, digging into the company's financials, leadership team, and competition within its industry.

In summary, S&P 500 index funds are a good option for those who prefer a hands-off, "set it and forget it" type of investment and want a lower-risk option. Individual stocks, on the other hand, are better for those who want full control over their portfolio and are willing to spend time researching individual stocks and companies and taking on more risk for the chance to beat the market.

Mutual funds vs exchange-traded funds (ETFs)

Mutual funds and exchange-traded funds (ETFs) are two popular investment vehicles that offer investors a low-cost way to gain exposure to a diversified portfolio of securities. However, there are some key differences between the two.

Mutual funds and ETFs are similar in that they both represent managed "baskets" or "pools" of individual securities, such as stocks or bonds. They both offer exposure to a wide variety of asset classes and niche markets and can be used to create a diversified portfolio.

Management

Mutual funds come in both active and indexed varieties, but most are actively managed by fund managers. On the other hand, most ETFs are passive investments pegged to the performance of a particular index, although they can also be actively managed.

Trading

ETFs trade like stocks on a stock exchange, with price changes throughout the day. Mutual funds, on the other hand, are bought and sold through a fund house at the end of the trading day at the Net Asset Value (NAV). This means that mutual fund orders are executed once per day, with all investors receiving the same price, whereas the price at which you buy an ETF will likely differ from the prices paid by other investors.

Minimum Investment

ETFs do not require a minimum initial investment and are purchased as whole shares, usually for the price of just one share. Mutual funds, on the other hand, typically have a flat dollar amount as a minimum initial investment and can be purchased in fractional shares or fixed dollar amounts.

Costs

ETFs have lower expense ratios than mutual funds, but they may have trading fees. Mutual funds can be purchased without trading commissions, but they may carry other fees, such as sales loads or early redemption fees.

Tax Efficiency

ETFs are generally more tax-efficient than mutual funds, as they may have lower turnover and can use the in-kind creation/redemption process to manage the cost basis of their holdings. A sale of securities within a mutual fund may trigger capital gains for shareholders, even if they have an unrealized loss on the overall investment.

The choice between ETFs and mutual funds depends on your investment goals, risk tolerance, and time horizon. ETFs are a good choice if you want to make intraday trades, use stop orders, limit orders, options, or short selling, or if you are tax-sensitive. Mutual funds, particularly index mutual funds, may be a better option if you invest frequently or if similar ETFs are thinly traded. Actively managed mutual funds may be preferable if you are looking for a fund that could potentially beat the market or if you are investing in a less efficient market.

Pros and cons of investing in the S&P 500

Pros of Investing in the S&P 500

The S&P 500 is one of the most renowned stock market indices globally, offering exposure to a broad range of leading companies across various industries. Here are some advantages of investing in the S&P 500:

• Diversification: The S&P 500 provides instant diversification, encompassing 500 large-cap US stocks from various sectors. This helps reduce the risk associated with investing in individual stocks, as losses from underperforming companies can be offset by gains from others.
• Long-Term Growth: Historically, the S&P 500 has shown strong long-term growth potential, with consistent returns over extended periods. While short-term market fluctuations may occur, the underlying trend has been upward, driven by the growth of the US economy.
• Accessibility: Investing in the S&P 500 is accessible to a wide range of investors. It can be done through index funds, exchange-traded funds (ETFs), or mutual funds, making it suitable for both individual investors and those with limited investment knowledge.
• Professional Management: The S&P 500 is managed by a committee that ensures the index accurately represents the US large-cap stock market. This committee regularly reviews and adjusts the index constituents, providing investors with confidence in the index's composition.
• Broad Market Exposure: The S&P 500 offers exposure to some of the world's most dynamic companies, such as Apple, Amazon, Walmart, and Johnson & Johnson. By investing in the S&P 500, individuals can gain access to these companies without spending hours researching individual stocks.
• No Intensive Research Required: Investing in the S&P 500 through an index fund or ETF means that no intensive stock-picking research is required. This makes it a good option for those who do not have the time or expertise to analyse individual stocks.

Cons of Investing in the S&P 500

While the S&P 500 has its advantages, there are also some potential drawbacks to consider:

• Market Volatility: The S&P 500 is not immune to market volatility, and periods of market downturns can result in significant declines in index value. Investors must be prepared to weather short-term price swings and potentially sustained periods of market downturn.
• Lack of Individual Stock Selection: Investing in the S&P 500 means giving up control over individual stock selection. While this provides diversification benefits, it may also mean missing out on potential gains from individual stocks that outperform the broader market.
• Concentration in US Stocks: The S&P 500 is heavily weighted towards US-based companies, which may result in a lack of exposure to international markets. Investors seeking broader international exposure may need to consider additional investment options.
• Inclusion of Underperforming Stocks: While the index is regularly reviewed, there may be instances where underperforming stocks remain in the index for a certain period, impacting overall performance.
• Dominated by Large-Cap Companies: The S&P 500 is dominated by large-cap companies, with its biggest constituents accounting for a significant portion of the index. This means it has limited exposure to small-cap and mid-cap stocks, which may have higher growth potential.
• No Exposure to Non-US Companies: The S&P 500 only includes US-based companies, which may be a drawback for investors seeking global diversification.

How to invest in the S&P 500

The S&P 500 is a stock market index, which means it is a list of companies that are grouped together, in this case, the 500 largest US companies by market capitalization. You can't invest directly in the index, but you can buy individual stocks of companies in the S&P 500 or invest in an S&P 500 index fund or ETF. Index funds typically carry less risk than individual stocks.

• Open an investment account: If you don't already have a brokerage account, you'll need to open one to buy investments. You can use the money you deposit into the brokerage account to purchase S&P 500 stocks or funds, which will then be held within that account.
• Choose your investment type: You can either buy individual stocks of S&P 500 companies or buy a fund that includes all the companies in the index. The latter is ideal for beginner investors since they provide broad market exposure and diversification at a low cost.
• Select your fund: If you choose to invest in a fund, you'll want to look at its expense ratio (the cost that the fund manager will charge you over the year as a percentage of your investment) and sales load (a sales commission charged by the fund manager). S&P 500 index funds have some of the lowest expense ratios on the market.
• Determine how much to invest: Figure out how much you're able to invest and add that money to your brokerage account. You'll want to add money regularly to the account and aim to hold it there for at least three to five years to allow the market enough time to rise and recover from any downturns.
• Buy the investment: Go to your broker's website and set up the trade, inputting the fund's ticker symbol and the number of shares you'd like to buy based on how much money you've put into your account.

Advantages and Disadvantages of Investing in the S&P 500

Advantages

• Exposure to the world's most dynamic companies: The S&P 500 includes some of the world's top-performing companies, such as Apple, Amazon, and Microsoft.
• Consistent long-term returns: The S&P 500 has historically provided strong annual returns over the long term, yielding an average annual return of 11.28% from 1950 to 2023.
• No intricate analysis required: Investing in the S&P 500 through an ETF or index fund means investors do not need to research or pick individual stocks.
• Can serve as a core holding: S&P 500 index funds and ETFs are liquid and trade with tight bid-ask spreads, making them ideal as core holdings for investment portfolios.

Disadvantages

• Dominated by large-cap companies: The S&P 500 is dominated by large-cap companies, with its 10 biggest constituents accounting for about one-third of the index. This means it has limited exposure to small-cap and mid-cap stocks that may have higher growth potential.
• Inherent risks of equity investing: The S&P 500 is subject to the risks of equity investing, including volatility and downside risk, which may be difficult for newer investors to tolerate.
• Only includes US companies: The S&P 500 only includes US-based companies, so it won't provide exposure to international companies.

Costs of investing in the S&P 500

When considering investing in the S&P 500, there are a variety of costs to take into account. Firstly, there are the expense ratios, which are the ongoing costs of holding an investment. These tend to be low for index funds as they are passively managed. For example, Vanguard's S&P 500 ETF (VOO) has an expense ratio of 0.03%, while the Vanguard 500 Index Fund Admiral Shares (VFIAX) has a ratio of 0.04%.

There may also be minimum investment requirements to consider. Some S&P 500 ETFs have a low minimum investment, sometimes only requiring the amount of a single share to get started. For instance, the SPDR S&P 500 ETF requires a minimum investment of $464.68. However, some index funds have higher minimum investments, such as the Vanguard 500 Index Fund Admiral Shares, which requires a minimum investment of $3,000.

If you are investing in individual stocks, you will need to pay the cost of the share, which varies by company. Some shares can be purchased for under $100, while others cost $350 or more.

Additionally, if you are using a broker, you will need to factor in any fees they charge for their services. Some brokers offer low-fee trading options, so it is worth shopping around to find one that suits your budget.

Finally, there are the taxes and fees that come with actively managed portfolios. Over long-term horizons, the S&P 500 typically produces better returns than these actively managed portfolios once these additional costs are taken into account.

Frequently asked questions