What is the S&P 500?

Understanding the S&P 500

Standard & Poor’s is a financial services company famous for the S&P 500 Index, which it introduced in 1957. This index combines the stock prices of 500 companies across different sectors into one number, providing a snapshot of the US stock market’s performance. The index is weighted based on the market capitalization of each company, which means that the most valuable and biggest companies have the greatest influence on it. This makes it a more accurate reflection of the US stock market.

Simple Explanation

The S&P 500 is like a stock scoreboard…

If you need a simple way to see how the stock market is doing, just take a look at the S&P 500. It uses a special formula to sum up all the stock market action into one number.

Who are the members of the S&P 500?

In general, the S&P 500 is made up of the top 500 US companies that are publicly traded and have a market capitalization of at least $13.1B as of January 2023. These companies must be profitable, based in the US, and have publicly traded shares available. Companies that are highly valued but not profitable cannot be added to the S&P 500, even if they are among the top 500 publicly traded companies in America. Collectively, these 500 members represent roughly 80% of all publicly traded stocks in the country. The final decision regarding membership is made by S&P Dow Jones Indices, the index’s administrator.

How is the S&P 500 calculated?

It requires some math to go from a bunch of numbers to just one. The S&P 500 index is determined by market capitalization, which is the total value of a company’s shares (found by multiplying the stock price by the number of shares available).

The S&P 500 is determined by a simple equation: The numerator represents the combined market capitalization of the 500 members. The denominator remains a confidential number that the S&P doesn’t disclose. What’s key to grasp is that the stock prices of these 500 companies impact the movement of the S&P 500, and the companies with the highest market caps carry the most weight in influencing the index.

How to calculate a company’s weight in the S&P 500?

The top three companies to hit $1 trillion market caps were Apple, Microsoft, and Amazon. With their significant presence in the S&P 500, any shifts in their stock prices have a greater impact on the index compared to companies with lower valuations.

If you want to figure out how much weight a specific company holds in the S&P 500, just divide its market cap by the total market cap of the index. For instance, if a company has a market cap of $50 billion and the S&P 500’s total market cap is $5 trillion, then that company has a 1% weighting.

How is the S&P 500 useful?

• It gauges the performance of stocks: With 80% coverage of publicly traded stocks in the US, the S&P 500 provides a good indication of how the US stock market is faring overall.
• It’s a benchmark against your portfolio: Investors typically have a group of stocks they consider their stock “portfolio.” While looking at the percentage gain is one way to evaluate its performance, comparing it to the S&P 500 provides a more comprehensive analysis. Comparing your portfolio’s performance with the S&P 500 can give you insight into whether you’re outperforming or underperforming the market. Instead of creating your own investment mix, you could simply track the S&P 500 (more on that below).
• It’s tracked by funds: Many investors prefer not to hand-pick stocks and instead favor investing broadly in the US stock market. An easy way to accomplish this is by purchasing shares of a mutual fund or ETF. Several mutual funds are constructed with underlying stocks that replicate the composition of the S&P 500. By doing so, investors can have a piece of the S&P 500 with just one purchase, and their returns will move in line with the S&P 500.

S&P 500 vs. the Dow

The Dow Jones Industrial Average, also known as “the Dow,” and the S&P 500 are both commonly used to gauge the overall performance of the stock market. However, there are distinct variations between the two:

Number of companies included:

• The Dow is super exclusive – it’s almost like being knighted by the queen. While this exclusivity brings prestige to the 30 members of the Dow, it also weakens the Dow as a measure of the stock market overall. The performance of the 30 largest companies may not accurately represent the entire market.
• The S&P 500 says it all – 500 companies are part of it. This makes it more inclusive and well-equipped to respond to the main question “what’s the stock market like today?”.

How the stocks are weighted:

• The Dow was at about 34,000 in January 2023. This number is determined using the index method, which takes into consideration the 30 stocks in the index and their stock prices. The company with the highest stock price carries the most weight, thus affecting the index the most.
• The S&P 500 is weighted based on market capitalization. Market capitalization is a more logical choice for weighting since it considers both stock price and the number of shares available in the market. The Dow’s weighting only considers one of these factors, and stock price alone doesn’t provide the most accurate representation of the stock market.

Keep in mind: The Dow is impacted the most by companies with a higher stock price, whereas the S&P 500 is influenced the most by companies with the largest market capitalization.

• The S&P 500 is calculated based on market capitalization, which takes into account both stock price and shares outstanding.
• On the other hand, the Dow is weighted solely by stock price.

S&P 500 vs. the Nasdaq

The S&P 500 is a broad index that covers companies from various sectors, providing a good representation of US stocks. In contrast, the Nasdaq is more tech-heavy. This is why the S&P 500 is seen as a more accurate reflection of the US stock market, while the Nasdaq is considered a better representation of the tech sector.

Limitations of the S&P 500

It doesn’t accurately reflect the state of the economy.

Many refer to the S&P 500 as an indicator of how well the US stock market is performing. There are those who go beyond that, seeing it as a reflection of the entire US economy. While the S&P 500 does play a role in Americans’ financial stability, it’s not the sole factor at play.

The S&P 500 tends to increase when companies are more profitable, as stock prices are mainly influenced by companies’ profit-making abilities. However, this doesn’t necessarily mean that workers’ incomes or economic happiness will also increase.

Since so many Americans own stocks in the companies in the S&P 500, when it goes up, it’s like a boost for their wealth. But when it goes down, it’s not so great for them.

Small companies and private companies are not part of it.

Even though the S&P 500 includes 80% of publicly traded stock in the US, it doesn’t factor in small businesses, private companies, or other companies that didn’t make the top 500. Therefore, it’s important not to assume that its performance represents all sectors and companies.

Disclosure: You can’t invest your money directly in a market index. Market indices are not subject to any fees or expenses.