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 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 65% of the entire index. In contrast, UK stocks account for just 3.2%. US stocks, therefore, are an area that no investor can ignore.

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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 and dates back to the late 19th century, when it was first compiled by Charles Dow. 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 exchange-traded funds (ETFs) will use the S&P 500, while active fund performance is often benchmarked against this index too. 

• How to invest using ETFs: a beginner's guide

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’s no shortage of ETFs and index funds that do so. Both 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, the Nasdaq is another favourite index among investors. It’s often used as 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, including the SPDR® Russell 2000 US Small Cap ETF GBP (LSE:R2SC)or L&G Russell 2000 US Sm Cp Qual ETF $ Acc GBP (LSE:RTWP). There is also the MSCI USA Small Cap index, which can be tracked using iShares MSCI USASmCp ESGEnh ETF USD Acc GBP (LSE:CUS1). 

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 pore over company results and monitor trends, meaning that the price of US stocks generally reflects the best approximation of fair value. So, there aren’t many undiscovered bargains. 

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

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 two active options: Jupiter Merian North American Equity and Artemis US Smaller Companies.

Is this a smarter way to play US stock market?

Over the past couple of years, the US market has become harder to beat due to the continued outperformance of a handful of large-cap tech stocks.

Companies such as Microsoft (NASDAQ:MSFT), Nvidia (NASDAQ:NVDA), Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT), now make up a huge percentage of the index. They have also outperformed the broader index. 

The so-called Magnificent Seven, which also includes Facebook-owner Meta Platforms (NASDAQ:META) and Tesla (NASDAQ:TSLA), now accounts for around a third of the S&P 500 and around 20% of the MSCI World Index.

As the weightings to those seven stocks rises, the performance of the index becomes more reliant on their fortunes. Most index funds and ETFs are market-cap weighted, which means the companies are weighted according to their total value relative to the index.

To address the risk of over-concentration, last summer the Nasdaq 100 implemented a “special rebalance” in order to trim exposure to those seven tech stocks.

An alternative option to reduce concentration risk is to consider index funds and ETFs that track an equal-weighted index, which holds each company in equal proportion. For example, an equal-weighted FTSE 100 index would have a 1% weighting to each constituent.

One of the main benefits is that an equal-weighted ETF avoids being overexposed to stocks that have become overvalued or, worse still, potentially part of a bubble.

Another plus point of an equal-weighted index is that it offers more exposure to parts of the market that have performed less well in recent years. Going forwards, if there is a broader set of winners in US markets then this approach will, in theory, capitalise on that more than the more traditional and common market-cap weighted indices.

The trouble is there is much less choice in terms of index funds and ETFs tracking an equal-weighted index. Examples on interactive investor include the Invesco S&P 500 Equal Weight ETF Acc GBP (LSE:SPEX) and Xtrackers S&P 500 EW ETF 1C USD (LSE:XDEW). Each individual share will generate 0.2% of the returns achieved by these two ETF as a whole. 

And remember before you invest internationally…

All foreign investors - including those of us in the UK -  wanting to buy shares in individual US companies must complete a simple form called a W8BEN.

This form must be completed if you are intending to buy US shares within a trading account or ISA. You do not need to do this to trade US shares within a SIPP. 

Completing the form reduces tax paid on interest and dividends on US shares to 15% from 30%. Once complete, the form will remain valid for three years before you need to renew.