Latest / Marci talks money (and life) / Understanding the S&P 500: How Index Investing Works with Tom Bernard
Transcript
- Marci (00:16) Hello, I am MoneyMarci. Welcome. I am thrilled to welcome today's guest, Tom Bernard. Tom is a finance professional with more than two decades of experience analyzing markets, taxation systems, and corporate economics. He holds an MBA from the Wharton School at the University of Pennsylvania, a Master of Science and Taxation, and dual undergraduate degrees from the University of California, Berkeley. Earlier in his career, he worked in financial analysis and valuation at firms including PWC and Arthur Anderson. A passionate educator, Tom has taught personal finance at the City College of San Francisco, helping students navigate the complexities of investing with clarity and confidence. Tom is the author of The Index of America: How the S&P Works and Why You Should Invest in It. Welcome, Tom. Tom Bernard (01:13) Hi, Marci. Thanks for having me. Marci (01:15) Well, I am thrilled to have you here. It looks like you knew right from the start you were gonna go into a financial field. Tom Bernard (01:22) Yeah, straight out of college, I was very focused on the financial aspects of life and finance as a career. Absolutely. Marci (01:31) started with a double bachelor and the masters of taxation, was that all at one fell swoop? Tom Bernard (01:37) Yeah. The bachelor's was during one stint and then the masters in taxation was while I was working, actually at PWC. They allowed you to go to school part time at night. So I took a class a semester. So that took me a few years to do. Marci (01:53) And then you went back again to Wharton. Tom Bernard (01:56) And then I Yes. And then I stopped working at PwC and got my master's in business. But ended up back in public accounting and finance. And it's been a you know quite a ride. Everything from shutting the doors or turning off the lights at Arthur Anderson to you know and living through the dot com boom and bust to now the latest and greatest AI boom. Marci (02:20) So did you grow up in a family talking about financial literacy? Is this kind of like a family business or area? Tom Bernard (02:27) Great question. I really came to finance a little bit later in life. After I left home, went to college, my parents got divorced, and I learned very quickly that I had to take care of my finances and not only earn money, but also figure out how to grow it and make it work as effectively as possible for me. So I got really into studying and analyzing not only the markets and investing, but also understanding what my options were as an a young adult. So that's really what where my passion started in investing. But I started with real estate. So I would manage an apartment building during college and really got interested in investing in real estate. And my first job was as a real estate market analyst and got into valuing real estate and then that just morphed into other things like businesses and just went from there. Marci (03:14) So then after you keep doing all of these things you then decided, you know what, I'm gonna write a book. Tom Bernard (03:20) So that came much later. In the meantime, I got married, had a couple kids, and obviously, you know, being married is a incredible partnership. And we talked about finances all the time. And my wife was pretty adamant that she really wanted me to educate our kids on finances. So we had, you know, kind of a summer reading program. We'd go through different books and they're now in college. And over the course of talking with them, I kept, you know, recommending the S&P 500 and would clip articles and have like a little notebook where I kept everything. And after probably a decade or so, I had a pretty substantive base of articles and knowledge and things that I thought were really interesting about the S&P 500. And I thought, okay, it's probably enough to actually put together and really it was just initially for my family and for the kids so that they'd have something to refer back to as they you know went through their investing lives and the objective was really the ups and the downs. Right, of the market, because it's really easy to stay invested when you when the market's going gangbusters and you're hitting all new highs. But anyone that's lived through the dot-com bust and the great financial crisis understands that it's really during the downturns that you need to have really some faith and being able to refer back to something and understand how integral the S&P 500 is into the overall economy, I think would be helpful in terms of helping people stay the course. So that was the genesis for writing it. Marci (04:49) And I don't want to give away anything from your book, but can we talk about what the S&P is? Tom Bernard (04:55) Of course, of course. So the S&P 500, Standard and Poor's five hundred, is basically five hundred of the largest companies in the United States. And it started back in the fifties. Just to take a couple steps back, Standard and Poor's was initially two different companies, Poor's Publishing and Standard Statistics Company. And so Standard Statistics Company started really tracking indexes with the the Standard 90 on a weekly basis and that grew eventually to over 400 companies and then when they merged with Poor's Publishing in the 1940s they ultimately came up with a new larger index that had about 480 and over time it eventually relaunched as the S&P 500 in 1957. But one of the things that's really interesting about the S&P 500 is that it was designed to capture the economic vitality of the United States. And so when they established the baseline, so right now the S&P 500 is trading about 7,500. When they were establishing the baseline, they had to reset that number. And so they used the era during World War II when there was just tremendous economic output and productivity. And so they measured kind of the weekly economic output and the business creation, the business value creation during 1941, '42 on a weekly basis, and they came up with an average number. And that baseline number was 10. Okay, so from early 1940s, that number was 10. When it was launched in 1957, it was 44. And now it's over 7,500. So that just gives you an indicator of kind of the tremendous growth that has occurred in the, you know, the S&P 500 over decades. But going back to it, 500 companies, there's 11 sectors, and one of the key hurdles to getting into the S&P 500 is to have a market capitalization that is large enough to meet the entry criteria. And right now that is about $22.7 billion. And they evaluate what that is on a periodic basis about every quarter. But over time that number has gone up. So the hurdle to get in has consistently increased. And during downturns it might go down a little bit. But over time that's gotten larger and larger. And so the, it really makes up the what they call the large cap funds. And so we have 500 companies over 11 sectors. And they are basically the market leaders in each of these sectors. So one of the good things is right now and for the last decade or so, information and technology has been leading the charge and represents a very significant portion of the S&P 500 value. You'll hear, you know, the Mag 7 or the top 10 companies make up over 35, 40% of the overall value of the S&P 500 right now. But in addition to the information and technology sector, there are other sectors where the S&P 500 owns the largest, most profitable and leading companies in those sectors, whether it's financials or healthcare or consumer products. So that in the future, should information and technology kind of no longer be leading the charge and something else comes up, such as healthcare or financials, if you own the S&P 500, you're already owning the most, the largest, most significant companies in those sectors. And you're likely to ride that wave. So one of my favorite financial authors is Jack Bogle. And he had a great saying, you know, 'Don't look for the needle, just buy the haystack'. And one of the great things about the S&P 500 is that if you buy it, you're pretty certain that you, that those 500 companies, you're going to own the up-and-comers in the future, right? They're likely to be in there. And if they're not in there, they're going to be added in there relatively quickly. So there's a couple different criteria that I really appreciate about the S&P 500. One we talked about was the overall market capitalization value, that $22.7 billion. But the other one is what they call a seasoning period. So the company must have been public for at least 12 months. And this is really important right now because as many people, many of your listeners might know, SpaceX just went public and there was a number of indexes that kind of bent over backwards to make sure that they could add the SpaceX in as soon as possible. And I think early in July, there's a number of indexes that will add it. The S&P 500 through the SPDJI, which is the index committee that determines not only what companies can be added, but the rules that they follow to add companies, opened up their consultation period to see if they should change the rules. So right now, the rules are that there's a 12-month seasoning period. A company has to be public for 12 months. They thought about potentially shortening that to six months, right? And there's also another requirement that they must be profitable over the prior four quarters. So a company could have had a loss in Q1 and Q2 and Q3, and then made a lot of money in Q4. And if they made enough to kind of wipe out all those losses and they were profitable in total over that four-quarter period, then they'd be eligible. Now, those two things are just eligibility requirements. So those are to be eligible to get in, but there's actually a committee of individuals that must make that selection and must positively say, yes, we're going to add this company and remove another company. So periodically, companies are added and removed from the S&P 500. And the ones to be added must meet the requirements that are in place at the time. But should the requirements change, so for example, right now it's 22.7. billion to get in, but let's just say five years ago it might have only been 15 billion. Well, if a company got admitted five years ago and it was 15 billion, it might today only be worth 20 billion, even though the hurdle has moved up to 22.7, it won't automatically get kicked out. But should there be another company that the index committee decides to add, they might use one of those smaller companies and say, you know what, we're going to take you out of the S&P 500 and we're going to put you in the mid cap. So it's not like they're getting kicked out and they're no longer worth investing in, but they're now no longer the large cap, they don't meet the large cap requirement and so they'll get moved down to the mid cap index and that will open up room for a new company to be added. Marci (11:19) Okay. So that five hundred is a it's a set five hundred until or unless in some point in the future they change it. There are five hundred stocks and if we're bringing one in we're kicking one out and if one doesn't make it anymore we gotta bring someone in to replace them. Tom Bernard (11:37) Yep, there's five hundred and they keep cycling in and out. And every year, you know, it changes, but about twenty or thirty come in and twenty or thirty go out. So there is this constant churn that happens. And they do it periodically, but you know, in the last few years it's been about twenty or thirty every year that come in and go out. Marci (11:54) Now, if I'm listening on the radio, I might hear about the S&P or I might hear about Dow Jones or about NASDAQ. What's the difference between those? Tom Bernard (12:00) Yep. Great question. the three main industries, you heard about the Dow Jones, DJI, and that is 30 companies. And one of the key things about that index is that that is a price weighted index. That index is based on the share price of those companies. So it has nothing to do with the value, the overall value of a company. You might hear that the market capitalization value, I mentioned the 22.7 billion dollar value for a company, but that the share price is heavily influenced by the number of shares that are offered and some other factors. So the Dow Jones is a share price index. And if, for example, they do a stock split or they do some share buybacks, that will influence the share price and that can influence that index. So the other one is the S&P 500, which we've talked about. And then the other common one is the Nasdaq 100. So the Nasdaq is an exchange and the 100 is there are 100 companies that are exclusively traded on that index or on that stock exchange. So those are three very, very common ones. And both the Nasdaq 100 is market capitalization weighted along with the S&P 500. But the S&P 500 will have companies from different markets, they can be traded on the Nasdaq or the New York Stock Exchange, doesn't matter. Whereas the NASDAQ 100 is limited specifically to companies on that exchange. And the Dow Jones also is kind of market exchange agnostic. Doesn't matter what exchange those companies are traded on. But once again, Dow Jones is 30, NASDAQ is 100, S&P is 500, S&P has the 11 sectors and represents about 80 to 90 percent of the overall total US market. Just to keep some fun facts, at the end of 2025, the total US stock market was worth about 67 trillion dollars. And the S&P 500 companies were worth over $60 trillion at the time. So, you know, represents a really significant portion of the US market. So some people say, well, why don't I just invest in the total US stock market, all 4,000 companies? And if you look over time over the last several decades, there is very little difference in the overall returns between the S&P 500 and the total US stock market. Marci (14:24) So when you're talking about the Index of America and how the S&P works and why you should invest in it, you're talking about investing in an S&P index fund. Tom Bernard (14:37) Correct. So the S&P five hundred you cannot actually directly invest in. It is just an index and you must have, you know, a brokerage that is created either a mutual fund or an ETF or some investment vehicle that you can invest in that will track that index. So you heard, you know, passive versus active funds. The passive funds just follow the stocks that are in that, or just purchase the stocks that are listed in that index. And so, for example, Vanguard is a brokerage. They offer an ETF that is now has over $1 trillion in assets, VOO. They also have a mutual fund equivalent, VFIAX. But that is just one brokerage. And there are many different brokerages, Charles Schwab, Fidelity, et cetera, that offer similar mutual funds and ETFs that also track the S&P 500. So one aspect of investing from a personal finance perspective that you need to be very careful of is that not all mutual funds and ETFs are created equal. And one of the most significant variables is the expense ratio. And so it's really important if you're going to invest in the S&P 500 that you do so through a low cost index fund. I like to use VOO, the Vanguard ETF as a benchmark, which has 0.03% as their expense ratio. And to the extent that you're paying, you know, a lot more than that, just need to be you need to understand why and if that's the best best choice for you. Cause you can invest in an S&P five hundred, but if it's in a high cost fund, you can be leaving a significant amount of your returns on the table. Marci (16:10) Right. Can you explain to our listeners the difference between an index fund and a mutual fund? You started going into it with the active and passive management. Tom Bernard (16:21) Okay. So the index fund is just is j there's an index that it will track. So the S&P five hundred is an index, the Dow Jones is an index, and the Nasdaq 100 is an index. And then the investment vehicles, you can have the ETF Exchange Traded Fund, you can have a mutual fund. those there are some technical differences, but right now there are many companies or many of the brokerages will offer effectively both, like Vanguard offers both the ETF and Mutual fund equivalents. The primary difference when I was getting into it was that the mutual fund only traded once a day at the end of the day, the prices are set. Whereas the ETF is something the exchange traded fund you can buy in and sell out during the course of the trading day. And a lot of day traders will use and other financial professionals will use the ETFs and trade them during the course of the day for different strategies. Whereas the mutual fund is generally more stable, it prices once a day. You know, doesn't matter when you put your buy or sell order in, it only is gonna transact the end of the of the day. Marci (17:28) Okay. Actually I was I was trying to go into that not all mutual funds are index funds. Tom Bernard (17:34) Yeah, yeah. No absolutely. So so index funds and the going back to passive versus active. So specifically, the Standard and Poor's issues a quarterly report called the SPIVA, Standard Imports Index versus Active Funds. And what they do is they actually track the performance of all of the mutual funds that are in existence at that time and and how they perform relative to their benchmarks because different mutual funds, if an active mutual fund, the manager of those funds will have a thesis or a focus in terms of different areas of the market. It might be one specific sector, okay, all we invest in is technology companies, or all we invest in is small cap companies, et cetera. And so when you measure those, the performance of those companies, you're gonna want to make sure that you do it against a relative benchmark so you're comparing kind of apples to apples. And one of the things that happens is an active fund will have people that are actively making decisions. They're buying and selling during the course of a day over the quarter, etc. And a couple things you need to keep in mind. One, those people need to get paid. No one wants to work for free, and they shouldn't. And then two, when they buy and sell, there's transaction costs, right? Every time you buy and sell something, the people are taking actions, they also want to get paid. So there's costs associated with that. But also there are tax implications, right? Those holdings might be short-term, long-term, et cetera. So there's also a tax drag. So you just have to keep in mind that with a passive fund, you have a committee that's making this decision or set of rules that have made the decision and come up with a effectively a list of stocks, the brokerage fund that manages the ETF or the mutual fund buys and sells those. And once, for capitalization weighted, once you buy them, that mutual fund and that ETF will go up and down as the value of those underlying stocks goes up and down, right? As the price of NVIDIA goes up, the value of the S&P 500 goes up. Right. Whereas in other funds, some people might say, well, I'm to take profits now and they will sell it, incur costs, potentially trigger taxes. And then they and then they have to buy something else that hopefully will go up as well. So the SPIVA report is really interesting because what they have found is that one, there's something called survivor bias. So the active, you know, the mutual fund industry creates mutual funds each and every day. And there are now more mutual funds and ETFs than there are actual stocks, right? So there are 4,000 stocks in the US. There are more than 4,000 ETFs and mutual funds in the US. Okay. So these are created on a constant basis. And then if they don't quote unquote beat the market or beat their benchmark they're quietly eliminated or folded into other funds. And so there's this huge survivor bias. And that's why you'll see advertisements that say, XYZ fund has beat its benchmark for the last three years. But they may have launched 15 funds three years ago and only one has actually beat the benchmark. Right. so the SPIVA report is really interesting because they track over the life of the investing universe. So I think right now they're at about 20 or 25 years. And so each five year period, they will track, okay, how are we doing against all of the funds that have been created that were created 20 years ago or 25 years ago? And I think more or less it's about 90%. You know, after about 20 years, the S&P 500 beats 90 plus percent of all of the active funds. And the reason for that is that one, it's really hard to buy make up you know buy and sell decisions on a constant basis that are effectively beating the market. But even if you can do that, you have to beat it by so much that it covers not only the amount of money that you, the active manager is being paid, but that expense ratio, right? So an index fund has a very low expense ratio. We talked mentioned Vanguard at 0.03%. Usually active funds will have a much higher expense ratio, 1%, 1.5%. And over time it is really hard for an active manager to beat the market by one or one and a half percent year over year, over decades. And then when you take into account the taxes, as I mentioned, the from buying and selling, the last one I saw was kind of mid-2024, but they did an after-tax analysis. And the S&P 500 beat, I think it was 97% of all active funds on an after-tax basis. Right. So it's just really hard not only to actually beat the market, but given all those other factors in terms of the expense ratios, the tax drag, not only buying but selling at the right times. I mean, it's just really, really hard to beat the market, which is why it's much easier to sit back and just buy the S&P five hundred. Marci (22:26) Right. If that's what you're going to measure against and this year you'll come up higher than the S&P and this year you'll be lower, index funds are a great way to consider, especially if you don't want to be researching funds all the time, whether it's researching individual stocks or researching mutual funds, index funds are a great option to have that comparison. Tom Bernard (22:49) Yeah, absolutely. And one thing, so we we mentioned the expense ratios, and it's really easy to see the costs and the expense ratio when you hire an active manager. But frequently when people say, I beat the market, they will only look at the buy point and the sell point, and they won't take into account any of the hidden costs in terms of how much time did they spend on making those decisions, right? How much tax impact did they have from that buy to sell? What was actually their cost associated with that transaction, et cetera? And you know, it's I can say this now after having gone back and looked, you know, it's really easy to think, I did great, you know, in a given year. And maybe you do, you know, beat the market for one year or maybe even two. But over time, it's really hard to do that, especially when you factor in all of the costs, right? If you say, well, you know, my time is worth zero, but I spent a thousand hours each year for the last three years. Right. Like that's a big hidden cost associated with that activity that you probably should take into account. Marci (23:51) Right, right. It's those hidden costs that we don't see and of course the real costs when you end up paying tax on something and the fees that are not always as easy to see. Tom Bernard (24:03) Yeah. But one of the things about the S&P 500 that I really appreciate is the peace of mind that people that don't have the time or effort or expertise to make those decisions can have by by selecting it because you've now kind of outsourced your investment decisions to the index committee that is a group of highly trained professionals with decades of experience that have established a very robust methodology in terms of the size, the sectors that they cover, the profitability, the seasoning, some very robust criteria. And so you can focus on doing the things that you're passionate about and not worry about the investments. Yes, the market goes up and down, but you can be confident that you're going to be capturing the market by investing in the S&P 500 via a low-cost index fund like VOO at Vanguard or VFIAX. Marci (24:55) Okay. Well Tom, this has been very interesting. Do you have anything else you'd like to mention that maybe we haven't covered? Tom Bernard (25:02) so When it comes to investing and the S&P 500 there's a couple different themes that come up repeatedly. One, you'll hear the Mag 7 and along with that, concentration, right? And there's a lot of concentration risk associated with that. And I just like to mention that there's a professor at ASU, Hendrik Bessembinder, that is updating a report or a paper that he did back in 2018 where he looks at a hundred years of stock market data in the US stock market and he compares it's about 30,000 companies to short-term treasury, so just 30-day treasury interest. and that interest is about 3% over time. And what he has found is that less than half of those 30,000 companies even beat the 3% interest. So created net positive value over the short-term treasuries. But when you go down even further, a very, very small percentage, less than 4% of the companies created or were responsible for all of the market value that was created over that last hundred years. 4%. So over history, it is very common for a small percentage of the companies to really be creating the vast majority of the value. And so what we're seeing now, when you have seven or 10 companies making up a third of the total market value, that has repeated throughout history and is not that uncommon. So just know when you hear you know concentration risks, etc., that is why capitalization weighted index funds work so well because once you capture that stock, you are able to kind of ride that value creation up as it gets created, You're not selling, you're not selling as you go. So something to just keep in mind. The concentration is a feature, it is not a bug of the index. Marci (26:59) Okay, that makes sense. Tom, thank you so much for being my guest today. We appreciate you taking the time to join us here. Tom Bernard (27:07) Well Marci it's been great. Thanks for having me. Marci (27:09) A reminder that the contents of this podcast is educational conversations with guests expressing their information to share and their opinions and is not to be used as recommendations or guidance for your own investment decisions. Use this information as a starting point to do your own research and determine what investments are right for you. Marci (27:32) To my listeners, I will be sharing a link to Tom's information in the show notes. Please check him out, he has a lot of interesting information. Don't forget to subscribe, leave us a review, and stay tuned. I'll see you next time. This has been MoneyMarci on Marci Talks Money (and Life). You got this.