History Says You Should Know These 3 Things Before Buying the Vanguard S&P 500 ETF (VOO)

With $1.7 trillion in total assets, the Vanguard S&P 500 ETF (NYSEMKT: VOO) is an extremely popular exchange-traded fund (ETF) within the investment community. It provides instant access to the S&P 500 index. And the expense ratio of 0.03% is very compelling.

Even Warren Buffett recommends this fund as a leading investment choice for most people who want exposure to the stock market. Are you looking to buy this ETF? History says it's crucial to know these three things before investing any money.

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Portfolio concentration

The first thing investors need to know about the Vanguard S&P 500 ETF is that it is extremely concentrated these days. This fund tracks the S&P 500, but this benchmark is heavily skewed toward the world's most valuable businesses. The top 10 stocks in the portfolio make up 38% of the entire ETF. That means the other 490 or so companies fill out the remaining 62%.

Throughout history, there has never been a time when the S&P index was this concentrated. During the dot-com era, the top 10 stocks then represented 27% of the benchmark.

As you would imagine, technology stocks dominate. The information technology sector as a whole accounts for 37% of the ETF. Nvidia, Apple, Alphabet, Microsoft, and Amazon are the leading five positions. As a group, they are squarely in the middle of the artificial intelligence boom. This exposure includes chip manufacturing, cloud computing, enterprise software, and consumer-facing applications.

When buying this fund, you are making a bullish bet on the economic prospects of this revolutionary technology. If this doesn't agree with your line of thinking, then perhaps it's best to allocate your capital elsewhere.

Average return

The last decade has been particularly special from a performance perspective. The Vanguard S&P 500 ETF has generated a total return of 314% over the last 10 years (as of Aug. 19). Had you invested $10,000 back then, you would have $41,400 today, for an annualized rate of return of 15%. From a historical point of view, this fantastic gain is significantly above average.

Since the S&P 500 index was created in 1957 in its current form, the benchmark has produced a yearly total return of around 10%. A starting $10,000 sum would grow to a much lower 159% in 10 years based on this performance.

This means that investors hoping for the past decade's performance to repeat in the next 10 years should probably temper their expectations to avoid disappointment. The main concern today is that the market's overall valuation, as indicated by its cyclically adjusted price-to-earnings ratio (CAPE) of 42, is historically elevated. The CAPE ratio smooths out economic fluctuations to assess longer-term valuation extremes, and its current measure is a warning sign.

Of course, the S&P 500 index could continue its unbelievable run. Passive investment vehicles keep attracting capital, adding huge demand for equities. And the market is being driven by elite tech companies that have tremendous growth potential. However, it's always a good idea not to bank on monster returns. Assume that there will be a reversion to the mean.

Ongoing volatility

The third thing that investors want to keep in mind is how normal volatility is. Major drawdowns are a usual occurrence. Investors shouldn't be surprised at all to experience a correction about every one to two years and a bear market every three to five years. This is par for the course.

In the long run, fundamentals are the key catalysts dictating stock returns. But over any short time frame, investor sentiment is what rules share prices.

This is true even among the most valuable companies. Apple has a market capitalization of $4.6 trillion. Its 52-week high is a notable 54% higher than its 52-week low. And this is for a business that lives in the spotlight.

The Vanguard S&P 500 ETF definitely won't be this volatile. However, it's important to have the right mentality the next time the stock market drops. Remember to always stay on track.

Neil Patel has positions in Vanguard S&P 500 ETF. The Motley Fool has positions in and recommends Alphabet, Amazon, Apple, Microsoft, Nvidia, and Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.