Even if you are just beginning to invest, chances are you’ve already heard about the S&P 500. The S&P 500 is a stock market index that tracks the stocks of 500 large-cap U.S. companies. Because it tracks such a big number of companies it is a great way to passively diversify your investments. It also typically offers similar or better returns than the overall stock market. This makes it a very popular investment.

You might already invest in it – like I do, or you might be thinking about starting. Maybe you just want to learn more about how it works.

In this post I talk about why most fund managers don’t beat the market and why you are actually better off investing in ETF’s that track index funds – like the S&P 500. 

Yes, the S&P 500 and other index funds will likely do better than most managed funds and they are a great option for passive investing. It’s not even me saying it, Warren Buffet says it, Joel Greenblatt says it and other specialists say it too.

However, those funds are not perfect and not necessarily optimal if you want to make the most of your soldiers. Here I explain the problem with the S&P500, according to Joel Greenblatt in his book “The little book that still beats the market”.

The first thing that we need to keep in mind is the basic principle of investing – you want to buy stocks for a low price and sell them for a high one. This is almost a cliche and I’m sure you’ve heard this before. Buy low and sell high. It’s a basic stock market principle.

Now back to the S&P 500.

• The S&P 500 is formed by the largest 500 companies in the S&P, but they are not all equally part of the fund.
• The S&P 500 is a market-cap weighted index. This means that this fund is constructed based on the market cap of the individual companies in each index. 

In case you don’t know what market cap is, it is the value of each stock times the total number of stocks in each company. 

• Because the S&P 500 is a market-cap weighted index, this means that the larger companies make up the largest portion of the S&P 500. 

This means that the most expensive stocks will be a majority of the fund. So systematically you will own more of the overpriced stocks and less of the cheaper stocks. 

Obviously this goes against the basic principle of buying low and selling high. 

You might be wondering what the alternatives are, and according to Greenblatt not all index funds are market-cap-weighted indexes. Some are equal-weighted, which mean the fund invests an equal amount of money in the stock of each company that makes up the index. You can also invest in the S&P 500 Equal Weight Index, which is an alternative to the traditional S&P 500. Another option is investing in value stocks indexes.

Even though the S&P 500 and other indexes are not perfect, it doesn’t mean they are not a good form of passive investing. There are many options to choose from, so it is worth doing your research. 

Those funds are already diversified, as they include a number of companies. However, I personally like to diversify even more and invest in different indexes including international, different sizes and sectors, as well as individual stocks. Also I always prefer to allocate only a small portion of my portfolio when I’m just testing a new investment.

This post is not a recommendation of any investments. As always do your research and speak to a financial advisor for more tailored advice.

Do you invest in the S&P500? Have you thought about this problem before? Let me know in a comment below!