If You Only Have One Investment, This Is the One You Need

Q: Which is a better long-term investment — a Nasdaq index fund or an index fund that tracks the Standard & Poor’s 500? — James

A: A Nasdaq fund could “play a supporting role in a diversified portfolio,” says Leslie Thompson, a financial adviser and principal at Spectrum Management Group in Indianapolis. But if you’re going to pick just one index fund for the core part of your portfolio, you’re better off buying a mutual fund or exchange-traded fund that tracks the Standard & Poor’s 500,” she says.

Why?

Before getting into the details, let's start with the basics.

Rather than picking and choosing "the best" securities to own, index fund simply buy and hold all the securities in a given market. By avoiding the stock selection process, index funds give you broad-based market exposure while being able to charge low expenses, which is a good thing.

The downside of this approach, of course, is that you won't ever "beat the market" or finish at the top using this strategy. In fact, by owning all the stocks in a market, you will by definition get average market returns. However, this also means you will never badly lag the market either.

If you opt for this strategy, the market you choose to index is a critical decision.

The S&P 500 is considered the broadest of the best-known U.S. stock indexes.

The S&P 500 tracks the 500 largest, most liquid stocks listed on the New York Stock Exchange and the Nasdaq — and across a spectrum of industries. “For a long-term core holding, the S&P 500 better represents the economic environment providing more diversified exposures to all sectors of the U.S.,” Thompson says.

By contrast, the most popular Nasdaq index, the Nasdaq 100, tracks about 100 of the largest non-financial companies that are listed on the Nasdaq. It’s considerably less diverse, with technology companies accounting for about 60% of its weighting, says Thompson. It’s also extremely top heavy. “Just two companies, Apple and Microsoft, make up 23% of the index,” says Thompson. The top 10 stocks, meanwhile, account for about half of the entire index versus less than 20% for the S&P 500.

This tech focus hasn’t been such a bad thing over the last decade, when it comes to performance. The USAA Nasdaq Index 100 mutual fund is up an average of 10.6% a year over the last 10 years, nearly three percentage points a year more than the Vanguard 500 Index fund.

The tradeoff: potentially more volatility.

You'll recall that when the dot.com bubble burst in 2000, Nasdaq stocks took a much bigger hit than the S&P 500. The downside for the Nasdaq 100 hasn’t been as extreme over the last decade, says Thompson, but this isn’t the norm. Keep in mind too that the Nasdaq composite index has yet to surpass its all-time peak of more than 5,000 which it reached in 2000.

The index’s strong performance of late, moreover, has been the result of outsize results from just a handful of companies. (You can probably guess which ones.) If and when these stocks tumble, so too will the index.