When it comes to the major U.S. stock indexes, the S&P 500 index is considered the best gauge of the overall stock market's performance and an indicator of how large U.S. corporations are performing.
With that in mind, here’s what all investors should know about the S&P 500 index, how it works, how you can invest in it, and why doing so could be a smart move.
What is the S&P 500 index?
The S&P 500 (also known as the Standard & Poor's 500) is a registered trademark of the joint venture S&P Dow Jones indexes. It is a stock index that consists of 500 of the largest companies in the U.S. It's generally considered the best indicator of how U.S. stocks are performing overall.
In simple terms, the S&P 500 is a measure of the performance of 500 of America's largest public companies. For this reason, the S&P 500 is a common benchmark against which investors evaluate the performance of their portfolios.
Each listed company doesn't simply represent 1/500th of the index. The S&P 500 index is weighted by market capitalization. This means that larger companies make up more of the index's performance. Massive companies such as Apple (AAPL -0.93%) and Amazon (AMZN +0.49%) have a greater impact on the S&P 500 index than relatively smaller companies like General Motors (GM -0.11%).
Although these are 500 large companies, there's a wide range of valuations. The largest companies in the index have market caps in excess of $4 trillion. This is several hundred times larger than the smallest S&P 500 companies, which have market caps of less than $10 billion.
Why use the S&P 500?
You may wonder why the S&P 500 is considered such a valuable market and economic indicator.
Because the S&P 500 comprises a broad basket of stocks, it includes the companies most widely held by individual investors. In fact, the 500 companies account for roughly 80% of the total value of the U.S. stock market.
Company weighting formula and calculation
The weighting formula for S&P 500 stocks is fairly straightforward. First, the company's market cap is determined by multiplying each company's outstanding share count by its current share price.
Next, the market caps of all S&P 500 components are added together. Each company's market cap is then divided by the total to determine its weight in the index. For example, if the combined market cap of all S&P 500 companies is $40 trillion and one company has a $1 trillion market cap, it would make up 2.5% of the index by weight.
Limitations of the S&P 500 index
By far, the most significant limitation of the S&P 500 index is that it is market-cap-weighted. Because larger companies carry proportionally more weight, the index's performance is highly dependent on a small group of large companies. Meanwhile, the smaller components of the S&P 500 have a minimal influence on the index's performance.
Another significant limitation of the S&P 500 is that it only includes large-cap companies listed on major U.S. stock exchanges. It lacks significant geographical diversity, although many of the companies included in the index operate globally.
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Is investing in the S&P 500 right for you?
Legendary stock market investor Warren Buffett has famously said that a low-cost S&P 500 index fund is the best investment that most people can make. It’s not difficult to see why:
- Over long periods, the S&P 500 has delivered annualized total returns of 9% to 10%.
- You can easily invest in a passive S&P 500 fund with virtually no investment fees.
- Investing in the S&P 500 is a maintenance-free investment you can simply buy and leave alone.
- Investing in the S&P 500 is a way to gain broad exposure to the profitability of U.S. businesses without excessive exposure to any individual company’s performance.
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