Why this ETF is my #1 recommendation for new investors

NOTnew investor? Welcome to the market.

Of course, even if you’ve only been ready and able to take the plunge for a short time, you probably already realize that there’s no shortage of advice. Most of them are well-meaning, and some of them can even be called “good.” If any of them include a recommendation for individual stocks during your foray into investing, take a moment and think seriously about another piece of advice you’ve probably heard before: buy an index fund representing a large slice of the market.

The index fund that I am going to recommend, however, is not the fund that I am sure is so highly recommended by other sources.

A wiser choice (for the most part)

You may have read or heard that the SPDR S&P 500 ETF Trust (NYSEMKT: SPY) is a great way to start your investing journey. And truth be told, if that’s the choice you end up making, you will indeed be off to a good start. This exchange-traded fund (ETF) encompasses approximately 80% of the total value of the stock market, allowing you to participate in the persistent (albeit cyclical) growth of the economy without forcing you to become a stock picker.

But if following the crowd isn’t your thing, you’ll probably do even better with the iShares S&P MidCap 400 Index Fund (NYSEMKT:IJH).

Some experienced investors might be surprised to see this choice as a better starting point, but there are specific reasons why the mid-cap fund might be a smart choice for newcomers.

While the S&P 500 is made up of companies considered large caps, the S&P 400 MidCap Index is made up of mid-sized US companies. This is not an absolute rule, but in general these organizations display a market capitalization between 2 and 10 billion dollars. That’s big enough to guarantee they’ll be around for a while, but too small to capture the attention of most investors (and the media).

While S&P 500 companies represent approximately 80% of stock market value and earnings, the next 400 companies that make up the S&P 400 Index collectively represent between 10% and 15% of the total US stock market value.

It is, however, a particularly powerful slice of the investment market. As Standard & Poor’s explains of its index: “Mid-cap exposure typically captures a phase of the typical business life cycle during which companies have successfully addressed challenges specific to small businesses, such as raising initial capital and managing early growth.” Standard & Poor’s adds, however, “At the same time, mid caps tend to be quite buoyant and not so large that continued growth is unattainable.”

In simpler terms, many of these organizations are in an ideal position for investors.

This unique advantage is reflected in the ETF’s long-term results. While the nearly 300% gain of the SPDR S&P 500 ETF Trust since the start of this century mirrors the gain of the index it represents, the MidCap 400 Index Fund has nearly doubled that performance.

Data by Y-Charts.

Don’t get too excited just yet, though. Take a closer look at the table. It may be months and sometimes even years when mid caps lag large cap stocks. These mid-sized stocks have underperformed since COVID-19 spread across the world, for example, creating challenges larger companies can more easily overcome.

If you really plan on being in the market for the long haul, these types of fixes are less of a concern.

Position yourself now for the inevitable challenge on the road

As I noted above, a stake in the SPDR S&P 500 ETF Trust remains a solid choice. Or perhaps the smarter option is to split the difference and own a share of both investments. This way, you don’t have to feel like you’re missing out on the unique benefit of either option.

And it’s not nothing.

Perhaps the biggest risk new investors face is how easily you can walk away from a long-term holding when it looks like other options might end up performing better. However, with a position in mid caps which historically outperform large caps, you still hold a smart, risk-adjusted opportunity to do just that. This dynamic makes it at least a little less nerve-wracking to stick with index investments when it’s psychologically difficult to do so…like after a big sell-off.

Consider that mid caps and large caps as a group may not reach their major lows at the same time, and the temptation to try to time trade entries and exits is further reduced.

Either way, the S&P MidCap 400 index fund still allows new investors to avoid the risky temptation of becoming a stock picker, especially without first building the right foundation for their portfolio.

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James Brumley has no position in the stocks mentioned. The Motley Fool has no position in the stocks mentioned. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.