The Standard & Poor’s 500 index (S&P 500) is a stock market index that monitors the stocks of 500 stock companies in the U.S. It provides an overview of the stock market’s performance by tracking the risks and returns of the biggest stock companies.
This index not only rates its top 500 stock companies rating by capitalization but by other factors additional factors. Yet, investors consider it as the basis for gauging and comparing other investments in the market.
How Does the S&P 500 Work?
The goal of the S&P 500 index is to track the market capitalization of the companies listed in the index. By market capitalization, also known as market cap, we refer to the total value of shares issued by a publicly-traded company. It is one way to evaluate the worth of a company in the stock market.
History of the S&P 500
Standard and Poor introduced the S&P 500 stock market index in 1957 to track the value of 500 large companies. These companies were listed on the NASDAQ Composite and the New York Stock Exchange (NYSE).
As of 1957, the heaviest weighted stock in the S&P index was the American Telephone and Telegraph, later known as AT&T. The AT&T currently sits at the 11th position in the index.
The economic boom that followed World War II seemingly boosted the index to nearly 700 in its first ten years. However, the S&P fell to about 300 in the following decade, between 1969 – 1989. This was believed to have been caused by inflation and stagnant growth of the U.S economy at that time.
A more remarkable fall in the stock market came with the Great Recession of the late 2000s. Between October 2007 and March 2009, the S&P fell by a further 57.7% in the nationwide financial crisis.
However, the S&P picked up again and, by March 2013, it had recovered from all its losses from the financial crisis. Over the last decade, the S&P has hit an all-time high and has risen above 400%.
What Companies Make Up the S&P 500?
A committee selects the companies that make up the S&P index. The committee reassesses the index at the end of every quarter. The selection of the constituting companies is usually based on size, liquidity, and industry.
There are specific requirements a company must meet to qualify for the S&P index. Some of the criteria include:
- An unadjusted market capitalization of at least $8.2 billion
- Public availability of at least 50% of the company’s stock
- A stock price of at least $1 per share
- Positive earnings for a minimum of four consecutive quarters
- A 10-K annual report
- A minimum of 50% of its fixed assets and revenue must be in the United States
As of December 2021, the top ten companies in the S&P 500 index include:
- Apple Inc. (AAPL)
- Microsoft Corp. (MSFT)
- Amazon.com Inc. (AMZN)
- Facebook Inc. (FB)
- Alphabet Inc Class A Shares (GOOGL)
- Alphabet Inc Class C Shares (GOOG)
- Tesla Inc. (TSLA)
- Berkshire Hathaway Inc. (BRK.B)
- JPMorgan Chase & Co. (JPM)
- Johnson & Johnson (JNJ)
Classifying by industry, the S&P 500 index as if August 2020 constituted of:
- Information Technology: 27.5%
- Health Care: 14.6%
- Consumer Discretionary: 11.2%
- Communication Services: 10.9%
- Financials: 9.9%
- Industrials: 7.9%
- Consumer Staples: 7.0%
How Do They Calculate the S&P 500?
To calculate the S&P 500, start by calculating the market cap for each component company in the index. To get the market cap, multiply the number of outstanding stock shares by its current share price to get its market value. For instance, a company with 5,000 shares at $30 each has a market cap of $150,000.
Next, calculate the total market cap for the index by summing the market cap for all comparable companies. The total market cap is the numerator for the calculation.
The divisible is the base number that can be used to make adjustments for changes in the number of outstanding shares for each component company. Adjusting this base number provides a steady series of data that can be used for analysis over time.
How To Invest in the S&P 500
First, you have to understand that the S&P 500 is not an investment company in itself. Instead, it is an index — a list of companies in the stock market you can invest in.
Attempting to invest in all index companies is an uphill task — imagine having to buy 500 separate stocks. The good news is that you can invest in index funds and Exchange Traded Funds.
The S&P 500 index weighs companies by their market capitalization. As a result, the effect of a single company’s performance can impact the whole index. For instance, a drop in the price of Amazon shares can have a ripple effect on the entire index.
This is the gap that index funds seek to bridge. They put the S&P 500 in an equal-weighted format such that each company has the same impact on the whole index. It’s just like having ten restaurants selling precisely the same food. You will most likely go for the one with the lowest price.
Before you settle with any index funds, you need to consider certain factors that may affect your return on investment. Such factors include the expense ratio and the sales load (sales commission).
What Is the Average Return?
Over the last century, the average annual return of the S&P 500 index has been 10%. Note that this return rate does not take inflation into account. As such, there is no guarantee that your stock investment will always return the average.
As a result of market factors, such as inflation, the stock investment return rate may differ across different years and different economic seasons. For instance, the S&P 500 ended the year a whopping 37% down in 2008. This was the period of the Great Recession.
One year after, towards the end of the financial crisis, the S&P 500 finished up 26%. Hence, one must have a long-term investment mindset to earn the 10% average annual total return. Also, investors have to acknowledge and take into consideration market volatility.
Is the S&P 500 a Good Investment?
As an investor, it is always wise to analyze and assess any investment before putting your money into it. The S&P 500 is no different. To figure out the profitability of the S&P 500, let us consider the benefits and disadvantages of this index.
Advantages of Investing in the S&P 500
- Broad Market: The S&P 500 covers a wide range of companies and their shares all at the same time. By investing in an S&P 500 index fund, you invest in the shares of about 500 different companies. This means that the value of your investment does not just depend on the rise or fall of one share alone.
- Lower Exchange Ratios: The costs of managing the S&P 500 investments are relatively low. Some index funds charge an expense ratio as low as between 0.05% to 0.07%.
- Less required efforts: Since you are investing in multiple shares by investing in one index fund, there may be little need to monitor each component share. This is a good fit for investors who may not have the time to track shares one by one.
Disadvantages of Investing in the S&P 50
- Less control over funds: While this may not be an issue for many investors, it may not go down well if there are certain companies you want to avoid supporting.
- Average earnings: If you’re an investor who seeks to leverage the movement of some particular shares that is time-sensitive, the S&P 500 may not be the best fit for you.
The S&P 500 vs Dow Jones
Both the S&P 500 and the Dow Jones Industrial Average (DJIA) serve the same purpose – to give you an overview of the stock market activities. However, they differ from one another in some ways.
The Dow Jones allocates greater weight to companies that have higher share prices. Unlike Dow Jones, the S&P 500 gives more weight to companies with a higher amount of publicly available shares.
Another difference lies in the method of selection. Dow Jones tracks the top 30 largest companies with the highest share prices. On the other hand, the S&P 500 provides a broader scope, including about 500 companies from different industries.
The S&P 500 Vs. NASDAQ
The NASDAQ Composite, known as the NASDAQ, includes all the stock listed on the NASDAQ stock market. To effectively compare the NASDAQ to the S&P 500, let us consider their different weighting and selection methods.
In the NASDAQ Composite index, the weight of a component company depends on its total market value. This implies that having a more significant market value places a company above another in the NASDAQ index.
Also, the NASDAQ index recognizes only stocks that are exclusive to the NASDAQ stock market. This is contrary to the S&P 500, which takes from different companies from various industry sectors.
The S&P 500 index provides you with an opportunity to invest in an extensive range of shares from different companies. You can get a good general perspective of the stock market in order to make better-informed decisions.
Every investor desires to maximize profits and minimize loss. So, it is recommended that you consult a Financial Advisor for a professional analysis to help you choose the best index funds for profitable investment.