The secret Tesla reveals about index investing

As I think most investors know by now, Tesla joins the S&P 500^® Index this week. What’s less known is that Tesla became one of the country’s top 500 stocks by market cap back in 2013.

That is a roughly seven-year gap and about a 3100% increase in Tesla’s stock price during that time. It’s an extraordinary story, and ironic in a way. The meteoric rise of a single company reveals something every investor should know about an investment strategy that in many ways is the exact opposite of individual stock-picking – index investing.

The stock market is actively picking winning and losing stocks every minute of every day in a rational, unemotional way based on all the information available about companies’ growth potential. Because of that, many investors – myself included – have come to believe that one of the simplest and most effective ways to manage money is to just “buy the market.”

At its heart, an index uses the pooled wisdom of the market as its manager. Harnessing that process is what index investing is all about: using objective criteria to win the day over human emotions and feelings. It’s why so few actively managed investments beat indexes over time.

But indexes come in many different shapes and sizes. Understanding those nuances is important.

Which brings us back to Tesla, which didn’t enter the S&P 500 Index back in 2013 because a committee of people chose not to include it despite the fact it was one of the largest US stocks even back then. Many investors find this surprising, and Tesla is far from the only one of America’s largest 500 companies by market capitalization not represented in the S&P 500 Index.

In my view, the smart way to buy the market is through:

Indexes that rely on objective criteria like market cap. I believe the very spirit of index investing is that it should be objective, transparent, and rules-based. The Schwab 1000 Index^®, for example, is made up of the top 1000 US common stocks as defined by market cap. In other words, it lets the market determine which companies get included. The S&P 500 Index uses a more subjective approach – via a committee – to decide which companies should enter the index, looking at factors like profitability, sector representation, or other considerations investors may not be aware of.

Indexes that are large enough to capture the fast-growing up-and-comers earlier in their success. The Schwab 1000 Index, for example, combines large-cap and mid-cap stocks in a single index. And it’s in those second 500 stocks – the smaller end of the companies in the index – where you can find the innovative “highflyers” before they possibly become part of the S&P 500 Index. Tesla became part of the Schwab 1000 Index in February of 2011, and then continued to grow rapidly for two years to become one of the largest stocks in the US. But there are many others. Companies like Lululemon, Moderna, Square, and DocuSign – none of which are in the S&P 500 Index yet.

My intent is not to beat up on any one index. But as index investing continues to take hold, I believe investors have something to learn from the Tesla story. I believe the ideal selection criteria for what goes into an index belongs in the hands of the dispassionate market. Market wisdom versus subjective choice.

It’s not enough to decide you want to buy the market. How you buy the market matters.