The S&P 500 Index

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.

S&P 500 vs. other major indexes

Although the S&P 500 is widely regarded as the best gauge of how the U.S. stock market is doing, there are several other indexes that can be useful for investors as well, including:

• Dow Jones Industrial Average
• Nasdaq Composite
• Russell 2000 (small-cap index)

S&P 500 vs. Dow Jones Industrial Average

The Dow Jones Industrial Average is a price-weighted index, meaning that the companies with the highest stock prices have the most influence on the index, regardless of their valuations. The Dow only lists 30 companies and excludes some of the largest stocks in the market, including Amazon, Alphabet, and Berkshire Hathaway.

Because the Dow is price-weighted, Goldman Sachs (GS -1.42%), with a share price of over $930 in mid-January, has about eight times as much influence over the Dow's performance as Walmart (NYSE:WMT), despite Goldman's market cap being roughly one-fourth of Walmart's.

For these reasons, the S&P 500 is generally regarded by most experts as a more reliable stock market indicator.

S&P 500 versus the Nasdaq

The obvious difference between the S&P 500 and the Nasdaq Composite Index is that stocks in the latter must be listed exclusively on the Nasdaq market. The S&P 500 is a mix of both Nasdaq and New York Stock Exchange (NYSE) stocks.

You may also notice that when tech stocks are underperforming, the Nasdaq Composite tends to underperform the S&P 500 because the Nasdaq has a higher proportion of technology stocks than the broader market, making it a more tech-heavy index.

Another key difference is that while the S&P 500 consists of large-cap stocks, the Nasdaq Composite contains all qualified stocks listed on the Nasdaq exchange, so it's more diverse in terms of market caps represented.

S&P 500 versus the Russell Indexes

The Russell Indexes are designed to provide benchmarks for the entire stock market. The Russell 1000 is the closest comparison to the S&P 500. It's a large-cap stock index comprising 1,000 stocks (twice as many as the S&P 500) and representing approximately 93% of the stock market.

There is also the more popular Russell 2000 index, which is considered the best benchmark of how small-cap U.S. stocks are doing. Collectively, the Russell 1000 and Russell 2000 are known as the Russell 3000, which is a total stock market benchmark index.

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.

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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