Investing Basics: How the S&P 500 Works

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The S&P 500 is a stock index that tracks the share prices of 500 of the largest public companies in the United States. Formally known as the Standard & Poor’s 500 Composite Stock Price Index and commonly referred to as the S&P 500, it’s one of the main tools used to follow the performance of U.S. stocks.

What Is the S&P 500?

When news reports and financial experts talk about what’s happening in “the stock market,” chances are they’re referring to the S&P 500.

Indexes like the S&P 500 track the prices of a group of securities. They aim to represent performance of a particular market, industry or segment of the economy—or even entire national economies. There are indexes that track nearly every asset class and business sector, from the U.S. corporate bond market to futures contracts for palladium.

The S&P 500 tracks the prices of large-cap U.S. stocks, or stocks of companies whose total outstanding shares are worth more than $10 billion. By following the S&P 500, you can easily see whether the largest U.S. stocks are gaining or losing value.

This is why the S&P 500 is often treated as a proxy for describing the overall health of the stock market or even the U.S. economy.

What Companies Are in the S&P 500?

The 500 largest U.S. public companies by market capitalization are represented in the S&P 500. Companies that are included in the S&P 500 are called constituents, and they are chosen to represent every major industry.

The S&P 500 is weighted by market capitalization, so each constituent’s share in the overall index is based on the total market value of all its outstanding shares. Constituents with larger market caps carry a higher percentage weighting in the index, while smaller market caps have lower weightings.

As of June 30, 2020, the following companies make up the top 10 constituents of the S&P 500 by index weight, according to S&P Dow Jones Indices.

S&P 500 Top 10 Constituents by Index Weight

Note that certain companies appear more than once—Google parent Alphabet Inc. appears two times. This is because Alphabet and other companies have more than one class of shares with a substantial market cap. For this reason, the S&P 500 may contain more than 500 stocks, even though it only includes 500 companies.

How Does the S&P 500 Compare to Other Indexes?

The S&P 500 is one of several leading equity indexes used to measure and understand the performance of the U.S. stock market. Here’s how it compares to two other common stock indexes.

S&P 500 vs. Dow Jones Industrial Average

The Dow Jones Industrial Average (DJIA), also known as the Dow, follows a much smaller number of companies than the S&P 500. The Dow tracks 30 “blue-chip” U.S. companies, judged to be the largest, most stable and most well-known companies that are leaders in their industries.

Unlike the S&P 500, the DJIA is price weighted, not market cap weighted. This means a company’s percentage weighting in the index is proportional to the price of its shares of stock. Components with higher share prices are given greater weighting in the index. This has a couple of important implications:

  • Smaller Dow components may be disproportionately influential. Because weighting is based on stock price, companies with higher stock prices have more influence on the level of the DJIA than they would in a market cap weighted index, independent of their market cap. A company with less expensive shares but a much greater market cap would play a smaller role in influencing the direction of the Dow.
  • The DJIA may experience more volatility. Because of its price weighting, the Dow can also experience sharper and more frequent highs and lows than the S&P 500. Consider this: Company XYZ’s stock is worth $200. When it drops $1 in value, the DJIA goes down a greater percentage than if a company with cheaper stock lost the same amount. This happens even though $1 is a smaller percentage of $200 than it is of, say, $20.

That said, over the long term, the S&P 500 and Dow have seen similar rates of return. From January 1920 to 2020, the DJIA averaged 10.1% annual returns, with dividends reinvested, while the S&P 500 averaged 10.3%.

S&P 500 vs. NASDAQ

The NASDAQ 100 tracks one hundred of the largest and most actively traded non-financial domestic and international securities on the NASDAQ Stock Market.

Like the S&P 500, the NASDAQ uses a market-cap weighting formula, though other factors influence stocks’ inclusion. To be part of the NASDAQ, stocks must have a minimum daily trading volume of 100,000 shares and have been traded on the NASDAQ for at least two years.

Unlike the S&P 500 and the Dow, NASDAQ includes some foreign companies and is heavily weighted toward tech companies. Because of that, the NASDAQ is less indicative of the overall U.S. market than it is of investors’ feelings toward the tech industry.

Over the last 10 years, the NASDAQ has averaged 42.6% annual returns while the S&P 500 has averaged 11.2%. Keep in mind, though, that its high recent returns are in large part due to its heavy tech weighting.

How to Invest in the S&P 500

Because it serves as a good stand-in for the overall U.S. stock market, many experts, including the likes of Vanguard founder Jack Bogle and legendary investor Warren Buffett, advocate for average people to invest in S&P 500 index funds.

In fact, Buffett even left instructions for 90% of his estate to be invested in S&P 500 funds upon his death. “There’s no better better than America,” he told CNBC’s Squawk Box.

To invest in an index like the S&P 500, you purchase shares of index mutual funds or ETFs that seek to mimic the performance of the index.

S&P 500 index funds and ETFs are among the least expensive fund choices available, and both funds and ETFs provide easy diversification. Buying just one share of an S&P 500 fund provides you with indirect ownership of 500 companies.

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