Investing in the US stock market: a beginner’s guide

As the world’s biggest market, the US cannot be ignored by any investor – here’s what you need to know.

The US is the world’s largest economy and is home to the biggest and most liquid financial markets. The total market value of US equities dwarfs that of the rest of the world. When measured using the MSCI All Country World index, the US accounts for around 60% of the entire index. In contrast, UK stocks account for just 4%.  US stocks, therefore, are a part of the market that no investor can ignore.

The main indices

The two most popular indices for US stocks are the Dow Jones Industrial Average and the S&P 500. 

The Dow Jones is the world’s oldest index of stocks, dating back to the late 19th century, when it was first compiled by Charles Dow. 

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Owing to its long history, the Dow Jones is often cited by non-specialist news outlets as a general gauge of the US economy’s performance. However, the Dow Jones is composed of just 30 stocks and is “price weighted”, meaning that stocks with the highest share price receive the greatest weighting. Therefore, most investors view it as somewhat flawed and prefer the S&P 500. 

As the name suggests, the S&P 500 is composed of 500 stocks. This means the index is a much more representative sample than the Dow. It is also market-capitalisation weighted, which is generally seen as a better way to construct an index, due to market capitalisation being a better gauge of the changing value of a listed company than price alone. As a result, most ETFs available to investors will use the S&P 500, while active fund performance is often benchmarked against this index. 

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The S&P 500, however, does have some quirks. In contrast to most big benchmark indices, the S&P 500 requires companies to have been profitable for four consecutive quarters to be eligible to join the index.  

The index also has a committee, which decides on membership based on certain “qualitative” factors. This is globally unique, with other big flagship indices such as the FTSE 100, Cac-40 or Dax 30, not having such requirements. 

For those looking to track the S&P 500, there is no shortage of ETF and index funds that do so. Both the Vanguard S&P 500 UCITS ETF GBP (LSE:VUSA) and iShares Core S&P 500 ETF USD Acc GBP (LSE:CSP1) charge just 0.07%. Generally, investors should avoid anything that charges more than 0.15% to track the S&P 500. 

Tech and small cap

Alongside the S&P 500, another favourite index of investors is the Nasdaq. It is often used a US tech index owing to its heavy weighting towards tech stocks. However, the Nasdaq itself is a stock exchange, with its name also being used by several indices tracking stocks that trade on it. The most important indices are the Nasdaq Composite and the Nasdaq 100. 

The Nasdaq Composite includes more than 3,000 stocks on the Nasdaq exchange, while the Nasdaq 100 includes 100 and uses a slightly different methodology. Investors are likely to see the Nasdaq Composite most frequently cited in the news. However, most ETFs available to UK investors mirror the Nasdaq 100, such as Invesco EQQQ NASDAQ-100 ETF GBP (LSE:EQQQ) or iShares NASDAQ 100 ETF USD Acc GBP (LSE:CNX1). 

When it comes to the small-cap end of the US market, the most popular index is the Russell 2000. This index is the 2,000 smallest companies of the Russell 3000 index. There are several potential ways that investors can track this index, such as the SPDR® Russell 2000 US Small Cap ETF GBP (LSE:R2SC) or L&G Russell 2000 US Small Cap ETF GBP (LSE:RTWP), among others. There is also the MSCI USA Small Cap index, which can be tracked using iShares MSCI USA Small Cap ETF USD Acc GBP (LSE:CUS1).

A global index?

Despite its historic role as an advocate of greater global trade and economic integration, the US economy is actually relatively closed to the rest of the world. Some countries such as Japan and Germany are highly reliant on world trade and, therefore, the performance of their economies is heavily tied to that of the overall global economy. However, the US economy is much more domestically focused, with its performance driven by consumer sentiment. 

The domestic-driven nature of the US economy is also reflected in the S&P 500. Although it fluctuates year to year, usually about 60% of earnings for companies in the S&P 500 are derived from domestic sales. This means that the key driver for the performance of the index is usually the overall health of the US economy.

However, this is changing. In recent years the trend has been for the S&P 500 to become more international. As Cullen Roche notes in his book Pragmatic Capitalism, in 1990 the S&P 500 generated 22% revenue from abroad, compared to today’s roughly 40%. He notes:

“The S&P 500 is no longer a US index. It is becoming a global index, and understanding its constituents requires a global picture. The big picture matters to market participants because US stock markets are becoming increasingly dependent on a stream of foreign revenues as they tap into foreign markets for business expansion.”

This also means that the S&P 500 moves increasingly in tandem with global equities. Roche notes that between 1990 and 1995, the average correlation between US and global equities was 29%. Between 2005 and 2010, the average correlation had risen to 73%. 

Active or passive?

When people say “markets are efficient” what they usually mean is that the US market is efficient. The original work on market efficiency was based on the US market, which is also the case for many subsequent studies. The US market is the most watched in the world. Thousands of professional investors and analysts are poring over company results and monitoring trends, meaning that the price of US stocks generally reflect the best approximation of fair value. There aren’t many undiscovered bargains. 

This means that the US market is incredibly hard to beat. Generally, fund managers underperform if they are stock picking in the S&P 500. 

The US market has also become harder to beat due to the continued outperformance of a handful of large-cap tech stocks. Stocks such as Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT) now compose a huge percentage of the index. They have also outperformed the broader index. 

Data shows that over the past decade only around 5% to 10% of active funds outperformed the US stock market.

However, not all US active funds should be written off. Our Super 60 list contains three active options: Jupiter Merian North American Equity, Artemis US Smaller Companies, and Premier Miton US Opportunities.