With the stock market’s recent volatility, you may be wondering if now is the right time to start investing. The answer is yes.
The stock market is trying to make its way back after seeing the biggest drop since the beginning of the Covid-19 pandemic.
Dramatic drops like these can be scary. But no matter what’s going on with the market at any time, it’s important to hold onto your investments. The stock market ebbs and flows, and corrections like these are just par for the course.
So if you’re trying to get into the market now, don’t wait. Anytime is a great time to get into the stock market, but it’s especially great to take advantage of lows like we’re currently seeing. And if you’re not sure how to get started, index funds might be a great choice for you.
An index fund is a type of pooled investment — either a mutual fund or an exchange-traded fund (ETF) — that tracks the performance of a particular market or sector. For example, there are index funds that track the performance of the S&P 500, the Nasdaq Composite, and the Dow Jones Industrial Average. Any of these funds can be great for your portfolio, because they mirror a broad, diversified swath of the stock market. But they have their differences.
To help you learn more about index investing, we’ve created a guide on these three popular large-cap indexes and spoke with two investment experts to help you decide which to add to your investment portfolio.
S&P 500 Explained
The S&P 500 is an index that includes 500 of the largest publicly-traded companies in the United States. But while it includes just 500 companies in the U.S. stock market, these companies’ shares make up about 70% of the value of the total stock market.
As a result, it’s often used as a proxy for the stock market as a whole. For example, when investors and analysts talk about how “the stock market” is performing, they’re often referring specifically to the S&P 500.
If you’re looking for just one index that can provide broad exposure to the large-cap U.S. market, the S&P 500 is it. It’s often used as a proxy for the market and combines some of the benefits of both the Nasdaq Composite and the Dow.
The S&P is float-weighted, meaning market capitalizations of the companies included are adjusted based on the number of shares available for public trading. It’s also market-cap-weighted, meaning companies with higher market capitalizations are weighted more heavily.
The Nasdaq Composite Explained
The Nasdaq Composite Index is a stock index that contains all domestic and international common stocks listed on the Nasdaq stock exchange. The Nasdaq was the first electronic stock exchange, and it’s known for being home to many well-known technology companies.
“The Nasdaq Composite Index has a greater number of companies in it but also skews much more heavily toward technology companies,” said Katherine Fox, a CFP and investment advisor with Arnerich Massena. “It’s easier to list on the Nasdaq than the NYSE, so some smaller, more growth-focused companies choose to list there. Tech companies are weighted at about 50% in the Nasdaq, and the Nasdaq is often used as a proxy for the technology sector.”
Like the S&P 500, the Nasdaq Composite is market-cap-weighted, meaning companies with higher market capitalizations are weighted more heavily.
The Nasdaq 100 is another stock index made up of companies listed on the Nasdaq stock exchange. But instead of including all companies on the exchange, it only includes 100 of the largest. The Nasdaq 100 has an even heavier concentration of technology stocks than the Nasdaq Composite.
The Dow Explained
The Dow Jones Industrial Average — often referred to simply as The Dow — is the oldest stock index. It was created by Charles Dow in 1884 and originally included just 12 stocks. Today, the index holds 30 blue chip large-cap U.S. stocks.
“Blue-chip companies are your well-known well-respected steady eddy companies with a long history of performing well in both up and down markets,” Fox said. “They also often pay dividends. Those 30 companies are chosen as sector leaders over different economic sectors in the U.S. The Dow Jones is intentionally built to be more diversified across sectors but only holds 30 companies.”
Unlike the S&P 500 and Nasdaq Composite, there’s less objectivity when it comes to which companies are included in the Dow. The companies are hand-selected by a committee based on their reputation, growth, sector, and more.
Also unlike the other two indexes, the Dow is price-weighted, meaning that each stock makes up a percentage of the index proportional to its current share price.
What Is the Difference Between the Three?
There are three major differences that help distinguish the S&P 500, Nasdaq Composite, and the Dow.
One of the clearest differentiators between these three indexes is the number of companies within them. On the two extreme ends of the spectrum, you have the Nasdaq Composite with more than 2,500 companies, and the Dow, which has only 30 companies. The S&P 500 is made up of 500 companies.
Another major difference between the three indexes is the sector diversification within them.
The Nasdaq Composite provides the least amount of sector diversification, as it’s made up primarily of technology companies. Of the total index, 52% consists of technology stocks, while the next largest sector is consumer goods, which makes up 16% of the index.
The Dow, on the other hand, is intentionally well-diversified across many sectors. Finally, the S&P 500 includes all 11 different sectors, with no single sector making up more than 30% of the index.
Each of the three indexes we’re comparing has different criteria for selecting the companies that will be included. First, the S&P 500 is made up of the 500 largest U.S. stocks that have a market cap of $13.1 billion or greater. The company that selects the stocks also takes into account the company’s public float, financial viability, liquidity, and sector representation.
The Nasdaq Composite has much simpler selection criteria. The index includes all domestic and international common stock listed on the Nasdaq stock exchange.
Finally, the Dow hand-picks the 30 companies that will be included, specifically looking for blue-chip companies with excellent reputations, sustained growth, and across a variety of sectors.
Which Should You Invest In?
The S&P 500, Nasdaq Composite, and Dow are three of the most popular and widely cited indexes in the stock market. And thanks to the invention of index funds, it’s easy to add indexes like these to your portfolio without investing in many stocks individually.
“The idea behind index investing is ‘if you can’t beat ‘em, join ‘em.’” said Robert Johnson, a professor of finance at the Heider College of Business at Creighton University. “Investors simply can’t afford to make oversized bets on individual securities. The intuition here is quite simple. Investment performance is uncertain. Fees are certain. And if you can minimize fees by investing in low-cost index funds, you put more of your hard-earned money to work.”
But when it comes to building your own portfolio, how do you know which to invest in? There are a few different strategies you could follow.
Invest in the S&P 500 for large-cap exposure
If your goal is to add large-cap exposure to your investment portfolio, you may only need one stock index to do that: the S&P 500.
“The S&P 500 hits that sweet spot where you have more companies and more sectors,” Fox said. “It’s not intentionally built to be diverse because it’s just the 500 largest companies. But in practice, you get a nice mix of big tech companies, financial stocks, and more. You get the broadest exposure to the U.S. equities market.”
Invest in all three for large-cap diversification
While there’s lots of crossover between the S&P 500, the Nasdaq, and the Dow, there still could be a place for all three in your portfolio. Each index has something unique to offer — the Dow offers diversification across sectors, the Nasdaq offers a wide variety of companies, and the S&P 500 offers a combination of both characteristics.
“There is also a behavioral aspect to spreading your investment across the three,” Johnson said. “During some periods of time, one will substantially outperform or underperform the others. When you are diversified across all three, you have less potential regret for not being fully invested in the index that performed the best. In essence, you make the decision to earn the average of the indexes and don’t second guess your choices.”
Don’t forget to diversify outside of large-cap stocks
There’s no doubt that large-cap stocks should have a place in your portfolio, and for most investors, they make up the largest share. However, they aren’t the only thing that should be in your portfolio.
“When you’re building out a portfolio, you really want it to be diverse, not only with companies of different sizes but also globally,” Fox said. “If you’re only talking about U.S. large-cap exposure, you’re talking about these three indices. When you’re looking at a portfolio more broadly where you want bond funds, mid and small-cap funds, and international funds.”
The good news is that, as with large-cap stocks, you can use index funds, as well as other mutual funds and ETFs, to gain exposure to different assets, company sizes, and regions to round out your overall portfolio. And always remember that when you invest in the stock market, you’re in it for the long game. Don’t sell your investments when the market dips. Hold on and sure enough, you’ll see your investments grow.