Today we are going to teach you about...
- What is the S&P500?
- How is the S&P500 calculated?
- Why invest or NOT invest in S&P500?
💡Key Takeaways 💡
- The S&P500 is a market-capitalization-weighted index of 500 leading U.S. companies and is considered a reliable indicator of the U.S. stock market's performance.
- The S&P500 offers diversification and historically strong returns, making it an attractive investment option for many investors.
- Investing in the S&P500 can be done through ETFs, mutual funds, index funds, or individual stocks, depending on your preferences and investment goals.
- Be aware of the risks associated with investing in the S&P500, such as market risk, concentration risk, and economic risk, and make sure it aligns with your investment goals and risk tolerance.
If you're looking to invest in the stock market, chances are you've come across the term "S&P500." But what exactly is it, and why should you care? In this article, we will answer all your questions about the S&P 500 and guide you through investing in this popular index. So let's jump right in!
What is the S&P500?
The S&P 500, or the Standard & Poor's 500, is a market-capitalization-weighted index of 500 leading publicly traded companies in the United States (currently, 503). In simpler terms, it's a collection of America's largest companies where bigger companies (measured by their total stock value) have more influence on the index's movement.
It is also float-adjusted, meaning that the weight of a company in the S&P500 is adjusted by the number of shares available to trade, 'floating.' This means only counting shares that can be publicly traded, not those held by company insiders or governments. This leads to higher liquidity stocks having a more significant percentage of the S&P500. Only these two metrics determine a stock's entrance to the S&P500.
It is widely regarded as one of the best representations of the overall performance of the U.S. stock market and used as a proxy indicator for the health of the American economy (albeit a weak relationship - you can have a weak economy with a strong S&P500, but you can't have a strong economy without a strong S&P500).
How is the S&P500 calculated?
Let's break this down simply: imagine the S&P500 as a pie chart. Each company gets a slice of the pie based on its size (market capitalization). Larger companies like Apple, Microsoft, and Amazon get bigger slices and therefore have more influence on how the overall index moves.
For example, if Apple represents about 7% of the total S&P500 market cap, then a 10% increase in Apple's stock price would move the entire S&P500 index up by about 0.7% (7% of 10%), all else being equal.
The S&P 500 is rebalanced quarterly, typically in March, June, September, and December. However, the top 50 holdings in the index are rebalanced annually. During these rebalancing periods, the index's constituents may be updated to reflect changes in market capitalization, mergers, or acquisitions. The S&P500 is also composed via the choices of a committee. It is not a strict rule to follow a stock's market cap as a sole metric to determine entrance to the index.
FORMULA:
stock weight in S&P500 (%) = (stock market capitalization)/(total S&P500 market capitalization)
- the higher the market cap of a stock, the more weight and influence it has on the S&P500's index movement
The actual calculation of the index is not disclosed to the public but would be somewhat simple to reverse engineer. The basic equation is:
INDEX VALUE: SP500 @ 4117
(total market caps off all stocks in S&P500) / (unknown divisor) = 4117
This "unknown divisor" is an adjustment factor that S&P uses to maintain continuity in the index when companies are added/removed or undergo corporate actions like stock splits.
S&P 500 Calculation Facts:
- no name overlaps, so stocks in the S&P500 cannot be in the S&P 600.
- SPGlobal doesn't list all 500 holdings outside of the TOP 10 along with a sector distribution breakdown
- 23% index weight cap per stock
- the sum of all equities with a weight > 4.8% must be <50% of the total index
Currently, the top 10 companies make up about 30% of the entire index, with technology being the largest sector at approximately 30% of the index. This means a small number of large tech companies have a significant influence on the S&P500's performance.
How does S&P500 compare to other indices?
The Standard and Poor's company also tracks and creates other indices, namely the S&P 1200, S&P400 (mid-cap), S&P600 (small cap), and the S&P1500. They all cover and track the performance of different-sized companies within the American economy.
SP400 + SP600 + SP500 ==> SP1500, which covers 90% of American equity capitalization
There are three other notable indices:
Dow Jones Industrial Average: tracks the performance of just 30 stocks across various industries and is price-weighted. So, the higher a stock's price is, the more weight it holds in the index.
- The primary difference between the S&P 500 and the DJIA is the number of constituent companies and the weighting methodology
NASDAQ 100: tracks the performance of just 100 stocks, only traded on the NASDAQ exchange.
- The primary difference between the S&P 500 and the NASDAQ 100 is the sector focus (NASDAQ focuses on tech and innovation) and the stock exchange on which the constituent companies are listed.
RUSSELL 2000: tracks the performance of 2000 small cap stocks (usually high-growth)
- The primary difference between the S&P 500 and the Russell 2000 lies in the size of the constituent companies.
To illustrate how these indices might react differently: If there's a major technology breakthrough, the NASDAQ 100 might surge while the Dow Jones might see more modest gains. Similarly, if small businesses are thriving due to new government incentives, the Russell 2000 might outperform the S&P 500.
Each index has unique characteristics and can expose different market segments. Understanding these differences is essential, and choosing the one that best aligns with your investment goals and strategy.
How to invest in the S&P500?
There are several ways to invest in the S&P 500, including:
Exchange-Traded Funds (ETFs)
- ETFs are a popular and cost-effective way to invest in the S&P 500. They are traded like individual stocks on exchanges and provide instant diversification by tracking the performance of the index. Examples of S&P 500 ETFs include the SPDR S&P 500 ETF Trust (SPY), iShares Core S&P 500 ETF (IVV) and the Vanguard S&P 500 ETF (VOO).
- Typical expense ratios: 0.03% to 0.09% annually (meaning you pay just $3-9 per year on a $10,000 investment)
- Minimum investment: As low as the price of one share (around $300-$450 depending on the ETF)
Mutual Funds
- Mutual funds pool money from multiple investors to invest in a diversified portfolio of stocks, bonds, or other assets. Some mutual funds are designed to track the performance of the S&P 500 index, such as the Vanguard 500 Index Fund (VFIAX) and the Fidelity 500 Index Fund (FXAIX). These funds offer an easy way to gain exposure to the S&P 500, although they may have higher fees compared to ETFs.
- Typical expense ratios: 0.05% to 0.20% annually
- Minimum investment: Often $1,000-$3,000, though some retirement accounts have no minimums
Index Funds
- Index funds are a type of mutual fund that aims to replicate the performance of a specific index, like the S&P 500. While they function similarly to S&P 500 mutual funds, index funds often have lower expense ratios, making them a more cost-effective option for long-term investors.
- Typical expense ratios: 0.03% to 0.15% annually
- Minimum investment: Similar to mutual funds
Individual Stocks
- If you prefer a more hands-on approach, you can invest in individual stocks that make up the S&P 500 index. This method requires more research and stock-picking skills, but it allows you to tailor your portfolio to your specific investment goals and risk tolerance.
- Commission costs: Many brokerages now offer zero-commission trading
- Minimum investment: The cost of at least one share of each stock you purchase
Key Terms Glossary:
- Expense ratio: Annual fee charged by funds to cover operating costs, expressed as a percentage of your investment
- Commission: Fee charged by brokers for executing trades
- Diversification: Spreading investments across different assets to reduce risk
- Portfolio: Collection of investments owned by an individual
- Brokerage: Company that facilitates buying and selling of investments
- Share: Unit of ownership in a company or fund
- Exposure: Amount of money you have invested in a particular asset or market
Why should I invest in the S&P500?
The S&P 500 includes 500 leading publicly traded U.S. companies representing various industries and sectors. This broad representation ensures the index is well-diversified This reduces the impact of any single company or sector on the index's performance. As a result, the S&P 500 provides a more accurate representation of the overall stock market and the U.S. economy compared to other indices that focus on fewer stocks or specific sectors. Money managers widely use this index, further solidifying its selection as the most popular investment index among retail and professional traders.
Investing in the S&P 500 comes with several advantages, such as:
Diversification: By investing in the S&P 500, you're effectively buying a small piece of each of the 500 companies, which helps to spread your risk across various sectors and industries.
Historically strong returns: Over the long term, the S&P 500 has provided investors an average annual return of around 10% (including dividends).
Passive investment strategy: Instead of actively picking individual stocks, investing in the S&P 500 allows you to passively track the market's overall performance, which can save time and effort.
Why should I NOT invest in the S&P500?
While the S & P 500 is a popular and reliable index for many investors, there are some arguments that you should consider before choosing to invest in it. Before investing in the S&P 500, evaluate your investment goals, risk tolerance, and desired market exposure to determine whether it aligns with your unique needs and preferences.
Concentration Risk: The S&P 500 is heavily influenced by the giants in the index, due to its market-capitalization-weighted nature. This dependence might lead to subpar performance if these companies falter.
Limited Exposure to Small and Mid-Cap Stocks: The S&P 500 is primarily composed of large-cap stocks, which means you could overlook the potential rewards and diversification that smaller and mid-sized stocks can bring to the table.
Lack of International Diversification: With its exclusive focus on American businesses, the S&P 500 fails to provide access to foreign markets. This limited scope could make your investments more susceptible to domestic economic fluctuations.
Passive Investing Method: By tracking the S&P 500, investors take on a passive approach that may not suit those who enjoy actively managing their portfolios and cherry-picking stocks.
Market Risk: The S&P 500's diversification advantages don't eliminate the inherent risks of the stock market, such as political upheavals or economic downturns. More conservative investments might be preferable for those with low risk tolerance.
Common Misconceptions About the S&P500
As a beginner, you might encounter some misconceptions about the S&P500:
"The S&P500 includes exactly 500 companies" - Actually, it currently contains 503 companies because some companies issue multiple classes of shares that are included separately.
"All 500 companies are equally important to the index" - Due to the market-cap weighting, the top 10 companies make up about 30% of the index's movement.
"The S&P500 represents the entire U.S. economy" - It only represents large, publicly traded companies, not small businesses or private companies that make up a significant portion of the economy.
"If the S&P500 goes up 10%, my S&P500 fund will go up exactly 10%" - Management fees, tracking error, and dividend reinvestment policies can cause slight variations.
"The S&P500 is only for experienced investors" - In fact, it's often recommended as an excellent starting point for beginners due to its diversification and simplicity.
Conclusion
Investing choices can be complex. The S&P 500 offers diversification, historical returns, and passive strategies. Yet, it could be better. Top companies dominate, small-cap exposure is limited, and international markets are absent. Remember, risk tolerance and personal preferences play crucial roles; following the S&P500 can give you insight into what other active money managers may be investing in and how they are positioning for upcoming economic conditions.
Here are some actionable steps based on your situation:
- New investors with small amounts to invest: Consider starting with an S&P500 ETF with low expense ratios like VOO or IVV
- Investors seeking more diversification: Consider pairing your S&P500 investment with international and small-cap funds
- Retirement-focused investors: Make S&P500 index funds a core holding in your 401(k) or IRA
- Conservative investors: Mix S&P500 investments with bonds to reduce overall portfolio volatility
Explore wisely, and let unpredictability fuel your financial journey.