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.
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.
How can you invest in the S&P 500 index?
You can invest in the S&P 500 index by purchasing shares of a mutual fund or exchange-traded fund (ETF) that passively tracks the index. These investment vehicles own all the stocks in the S&P 500 index in proportion to their weights.
The Vanguard S&P 500 ETF (VOO +0.48%), which trades just like a stock, and the Vanguard 500 Index Fund Admiral Shares (VFIAX -2.06%) mutual fund are two attractive options. Both have extremely low fees and deliver virtually identical performance as the S&P 500 index over time.
You can also buy S&P 500 futures, which are traded on the Chicago Mercantile Exchange; however, this is a far more complex way to invest than simply buying an index fund. These are essentially options that enable hedging or speculating on the index's future value.
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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.
FAQ
S&P 500 FAQ
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