Many investors face a situation where they’d like to simply invest in the total stock market but can’t because their 401(k) or other plans don’t have the right index funds. If you’re in a similar boat, you don’t have to settle for simply purchasing an S&P 500 fund if what you’re really looking for is the total market.
Before we get there though, fun fact: the S&P 500 represents about 80% of the total stock market by itself. That’s why Warren Buffett is content for you to buy an index fund containing most of the “big companies” because even when you’re in the S&P 500 you essentially have 80% of the market covered.
Some of the criticism of index investing is that if you think of the S&P 500 as an asset class itself, there might be a bubble thanks to investors that pile into the index. While it’s hard to imagine how 80% of the economy could be a bubble, studies have shown that being included in an index results in a measurable bump in the stock’s trading price.
If you’d like to eliminate that concern, buying the total market makes sense to me as you’ll capture the remaining 20% of the market capitalization not covered in the S&P 500.
Here’s a short video (6 minutes) of Jack Bogle, founder of Vanguard, talking about how Vanguard initially started with an S&P 500 but then eventually moved to offering a total stock market index fund (and about halfway through he explains why he thinks you should avoid owning the total world stock market).
Approximating the Total Stock Market
The market is often broken into arbitrary groups consisting of (1) Large Cap; (2) Mid Cap and (3) Small Cap funds. You can conceptualize it like this:
- Large Capitalization: Large cap stocks have a market cap over $10 billion dollars.
- Mid Capitalization: Mid cap stocks have a market cap between $2 billion and $10 billion dollars.
- Small Capitalization:Small cap stocks have a market cap between $300 million and $2 billion dollars.
Additionally, sometimes you’ll see stocks broken down categories of (1) Value; (2) Blend and (3) Growth. You can think of these categories like this:
- Growth: Growth stocks are companies that hope to grow profits at a very fast rate.
- Value: Value stocks are stocks trading at a discount relative to their intrinsic value.
- Blend: Blend is a mix of growth and value stocks.
These six factors are what Morningstar uses to construct its holdings box, which looks like the below for each index fund:
You can run whatever total stock market index fund you want through Morningstar to get your own analysis.
Once you have a holdings style for the fund you want to approximate, now you can turn to the index funds offered in your employer’s 401(k) or other retirement account to see what can be done to approximate the total market.
Approximating Step by Step
Let’s say that you don’t have the option of investing in Vanguard Total Stock Market, but want to replicate it given your fund offers.
Step 1: First, we pull up the Morningstar analysis. Here it is below.
Step 2: We check and see what we have in our 401(k) or other retirement account. Do we have an S&P 500 fund? Do we have Vanguard Large Cap? If so, we have what we need for the “large” cap fund. Now we just need to locate a mid cap or small cap fund. If only one of these is available, you can always approximate total market by combining the mid and small categories.
Step 3: Buy the funds in the percentage you need to approximate the total stock market. That’s it! Rebalance once a year to make sure you’ve got the ratio right. It shouldn’t take you more than 30 minutes annually.
If you’re looking for some combinations of funds that make sense to approximate the total stock market, check out the Boglehead wiki on this subject.
Let’s talk about it. Are you approximating the total stock market? How did you do it with the funds you had available?