It may seem complicated and inaccessible to invest in the S&P 500, but that couldn’t be farther from the truth. Investing in the S&P 500 is a fantastic method of diversifying your investments with minimal effort. In fact, for beginner investors, it may just be your single best option.
This post will cover what the S&P 500 is and how beginner investors can use it to build wealth.
Skip to a section:
- Overview
- 1. Understand Basics
- 2. Safety Net
- 3. Brokerage Account
- 4. Select Index Fund
- 5. Automate It
- S&P 500 Alternatives
What is the S&P 500?
To understand the S&P 500, you will need a solid understanding of the basics of the stock market. If you are still looking to build that, check out my post on stock market basics.
Now that we have that out of the way, what exactly is the S&P 500? The S&P 500 is an index meant to track the overall market, comprised of the top 500 companies in the stock market by market capitalization.
Market capitalization, or market cap for short, is the total value of a company on the stock market. It is calculated by multiplying the total number of shares by its share price. This would give you the full amount it would cost to purchase 100% of the shares of a company.
So, you can think of the S&P 500 indexing the top 500 largest companies in the stock market.
The companies in the index are also weighted by market cap. This means that if one company has twice the market cap of another, the larger company makes up twice the fraction of the S&P 500 as the smaller company.
For example, Apple has the largest market cap on the stock market, making up the greatest percent of the S&P 500 at ~6.2%. The exact percent weights of each company vary as its stock price fluctuates.
What is the Purpose of the S&P 500?
The purpose of the S&P 500 is to track the overall market. Since the S&P 500 holds the 500 largest market caps on the stock market, it has 80% of the market cap.
32,120,000,000,000 (S&P 500’s market cap)
/
40,511,838,000,000 (stock market’s market cap)
=80%
Since the S&P 500 holds such a large percentage of the overall market, it does a great job tracking it. When people talk about the market’s performance, they usually talk about the S&P 500.
When you invest in the S&P 500, you are investing in portions of every company in the S&P 500. For example, remember that Apple comprises 6.8% of the S&P 500. If you invested $100 into the S&P 500, you would own $6.80 worth of Apple. The other $93.20 of your investment would be made up of fractions of the 499 other companies.
The S&P 500 isn’t separate from the rest of the market. It is an amalgamation of many companies, which you can own portions of all at once.
Why Track the Overall Market?
The overall market comprises all the publicly traded companies in the US. Though this is far from every US company, as many are private, the overall market is a good indicator of US growth. If the US is prospering, more than likely, the market will prosper, and vice versa.
In general, people in the US think that the US will succeed. If you believe in the US’ success, investing and believing in the S&P 500 makes perfect sense. Why wouldn’t you root for your own team’s success?
Investing in a fund that tracks the overall market allows you to prosper along with the market. Unless you own a company, the US prospering doesn’t affect you much. However, you get a financial benefit if you are invested in the market. When the market rises by 10%, you get that 10% too.
This is one of the things that excites me most about the stock market and index funds, as silly as that sounds. Most people think that they have no access to benefit from US growth. But the stock market is an accessible method to gain this access.
Is the S&P 500 Good for Beginner Investors?
Yes. The answer is yes.
There are two primary difficulties with being a beginner investor: you don’t yet know enough to pick good stocks consistently, and it takes time to diversify.
For that first problem, there are a lot of factors and analyses that go into picking a stock. With a million things to think about it and varying investing styles, you won’t pick it up overnight. The S&P 500 helps to alleviate this issue.
Investing in the S&P 500 invests you in 500 individual companies. This removes the need to analyze and pick individual companies and hope they succeed. You are automatically investing in the top 500 companies in the stock market without opening a single Chrome page to research them.
As for the second problem, diversification is an integral part of any investment portfolio. It protects you from large swings in any individual investment while allowing you to grow. But as a beginner investor, it takes time to invest in enough companies to be properly diversified. Even if you invest in a different company each month, it takes 12 months to reach the optimal level of diversification.
Having 500 companies in your portfolio at varying weights is as diversified as you can get.
Let’s imagine a doomsday scenario. The iPhone 15 has an even bigger notch than the iPhone 14, and Apple’s share price goes to zero. Realistic, I know. Even in this situation, your portfolio tracking the S&P 500 would only drop by 6.8%. Remember, Apple is the single largest company on the stock market.
This sort of diversification means you can sleep well at night knowing that your portfolio will fluctuate, but it is safe from extreme swings. The only way for the market to drop by >20% is for the US to face a catastrophe.
Should I Just Invest in Individual Stocks?
When hearing that index funds diversify your investments, it’s tempting to want to invest in individual companies. If a company is going to see a big boom, you want to take greater advantage of that than a 1% S&P 500 increase.
The trick to this is picking the right company. A mind-blowing statistic is that around 80–90% of investors are unable to beat the average 10% returns of the stock market. This includes professionals and advisors who spend thousands of hours tracking the market.
To even get to the point of meeting or slightly exceeding the market’s returns, you must understand at least basic stock analysis. In the beginning, you will still be learning this skill. Plus, you will be missing out on minuscule returns if any.
If you are a more experienced investor, this calculus could be different. You may have enough trades and experience under your belt to make educated decisions that earn you more than the market. However, for everyone else, the overall market will do us just as well.
How to Invest in the S&P 500
Step #1: Understand the Basics
Before making any financial decision, it is essential to understand what you are getting yourself into. The riskiest investments are those where you don’t know what you are investing in.
Even though the S&P 500 is one of the safest investments, there will be ups and downs. If you don’t know what you threw your money into, you may panic when you see your investment drop by 5%. However, if you understand that the market will eventually recover because those 500 companies are fighting to prosper, you will sleep better at night.
Step #2: Have a Safety Net
I know, every financial blogger says to have a safety net. Well, that’s because it is a good idea.
If you’re investing in the S&P 500, having a safety net to dip into isn’t the primary concern here. If the S&P 500 goes to zero, the money in your safety net is pretty much worthless too.
Instead, the safety net is there to give you peace of mind. You know that no matter what happens with your investment, you have a backup plan. This gives you the freedom to invest and trust the long-term process. Emotional investors who are concerned with short-term performance will not succeed in the long run.
Step #3: Open a Brokerage Account
To invest in the S&P 500, you must select a brokerage account. This brokerage will act as the middleman for you to invest in any stocks you choose.
All large brokerages are going to support the usual S&P 500 funds. The only real difference to concern yourself with is the style and functionality of the brokerage. If you are more comfortable navigating one over the other, it’s better to go with it.
Step #4: Select an Index Fund
To invest in the S&P 500, you can’t simply invest in the S&P 500 directly. Instead, you invest in a fund that tracks the S&P 500. This index fund is what you will purchase on your brokerage.
Among the most popular index funds, the main variation is the expense ratio. A fund’s expense ratio is the percentage fee you pay on your holdings. For example, let’s say you hold $100 of an S&P 500 index fund. If the fund’s expense ratio is 0.5%, you would pay $0.50 annually.
The two most popular S&P 500 index funds are VOO and SPY. Of the two, VOO is the clear choice for me. Their performance will be virtually identical since they both track the S&P 500. But VOO’s expense ratio is .03% while SPY’s is .095. That is over triple the fees paid every year to hold SPY instead of VOO.
If you find another fund you are interested in, look out for a minimum investment. This could lock you out from accessing certain funds in the beginning. Neither VOO nor SPY has a minimum investment.
Step #5: Automate It
You know I couldn’t go a post without preaching automation.
Especially for beginner investors, automation is key. It’s easy to forget to invest one month or run out of money when you planned to invest at the end of the month. Or, if you struggle with emotional investing, you want to stop investing every time the market dips.
All of these problems can be solved by taking the decision-making out of investing.
Any large brokerage should allow for automatic investments. This allows you to automatically invest say $150 every month into VOO. You never have to think about the decision again because the system is already in place.
Years from now, you will no doubt thank yourself for setting this up. You will have amassed a significant amount of wealth passively.
Automation is even better for index funds than individual stocks.
The one concern with automating individual stock investments is that companies can degrade. One bad new CEO or major product decision and the company could head toward bankruptcy. In this scenario, it would be best to cancel your automated investments, liquidate your holdings, and find a new bull to ride.
However, with index funds, this situation is accounted for. If a company on the S&P 500 takes a dive like this, it will simply fall out of the S&P 500 and be replaced by a more prosperous company. All without you lifting a finger.
S&P 500 Alternatives
NASDAQ
The S&P 500 isn’t the only index tracking the overall market. Another notable index is the NASDAQ. The NASDAQ is very similar to the S&P 500 as it weighs its stocks, or constituents, by market cap.
The primary difference is that the NASDAQ has 3,000 constituents, compared to the S&P 500’s 500. This means that each company in the NASDAQ makes up a much smaller percentage of the NASDAQ than each company in the S&P 500.
A smaller percent weight of each company means that the NASDAQ experiences less volatility than the S&P 500 as companies fluctuate in share price. For investors looking for an even more stable investment, this may be a big plus.
The primary downside that makes it less popular is that the NASDAQ is historically worse at tracking the overall market than the S&P 500. If you are looking to track the overall market like most people, this tends to tip investors towards the S&P 500.
The popular fund tracking the NASDAQ is QQQ.
Dow Jones Industrial Average
The Dow Jones Industrial Average (DJIA) is the third most popular index. It tracks 30 companies in varying sectors. This low number of companies means you get far less diversification with the DJIA than with the S&P 500 or NASDAQ.
In addition, the selection process is unique. Whereas both the S&P 500 and NASDAQ simply use the market cap as a threshold for entry, DJIA also has qualitative considerations. If a company is a trusted household name, it is much more likely to be entered into the DJIA.
This selection process makes the process to get accepted into the DJIA unique and less straightforward. Investing in DJIA is about trusting their decisions about how solid a company is in addition to their hard statistics.
The popular fund tracking the DJIA is SPDR.
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