For investment strategies that focus on asset allocation using low-cost index funds, you will find either an S&P 500 matching fund or total stock market tracking index fund recommended as the choice to cover the U.S. stock markets. Even though a total stock market index tracks six to seven times as many stocks as are in the S&P 500, the returns of the two indexes are highly correlated, with just minor factors affecting the relative volatility of each.
Big Stocks Corner the Market
The S&P 500 index tracks the 500 largest companies out of the 5,000 or so that trade on the U.S. stock exchanges. However, those 500 companies account for 75 to 80 percent of the total stock market value in the U.S. Both total market and the S&P 500 stock index track stocks using a market cap -- company total value -- weighting, so the extra 4,000 or stocks covered by a total market index only account for at most 25 percent of the index value. The very large, multi-billion-dollar companies are the stock prices that have the greatest effects on the value of either type of index.
Small Stock Volatility
The companies covered by the S&P 500 include the large, generally less-volatile corporations operating in the U.S. Market sectors such as utilities and consumer staples are more heavily weighted in the S&P 500, and these stocks tend to be among the most stable. The smaller stocks that make up the rest of a total market index will include more-volatile small- and mid-cap companies. Smaller companies may offer potential for higher returns, but along with that potential comes a higher probability of volatility.
Adding S&P 500 Stocks
The one instance when the S&P 500 might be more volatile is when Standard & Poors' adds and drops stocks from the index. When components are changed, the new stocks being added tend to go up in value, because traders know the shares will soon be required holdings for the S&P 500 index funds. These stocks are already included in a total market index. A January 2010 article on the CBS MoneyWatch website called this phenomenon the "Google effect," because the price of Google shares significantly affected the S&P 500's short-term returns when the giant company was added to the S&P 500 in 2006. However, it is rare that a company of this magnitude is added to the S&P 500.
Differences Too Small to Measure
When looking at the historical results for the overall stock market, you would expect that a total market index would be slightly more volatile than the S&P 500 and also produce a slightly better long-term return. However, these differences might be too small to measure. A report published by ETF sponsor iShares noted that for the five-year period that ended in the middle of 2010, the correlation between each of three major total market indexes and the S&P 500 was 100 percent.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.