Stocks 101: What is the S&P 500?
What the heck is the S&P 500, and how does it work? Why is it relevant, and why do we care? These are questions we hear ALL the time. I do my best to simplify everything and give you the most straightforward answer.
In this article, I will break down the S&P 500 and provide a little back story on the history of how it came to be. I’ll segue into the pros and cons and give you the blueprints of why it matters and why we should care.
Also, I recommend you check out the Stocks 101: Dow Jones and how it works article, as that will give you more insight into how the S&P 500 impacts the stock market. Mainly because the S&P 500 is considered the most popular index to follow by financial professionals. Whereas the Dow is more prevalent in mainstream media and American households. Now that we know that let’s dive in!
Back Story
What is the S&P 500? The proper name is Standard & Poor’s 500, and this index represents the top 500 companies in the United States. An index would be a group of stocks that track a particular industry or segment in the economy. To give you an idea of which companies represent the S&P 500, these are the top 5 companies.
- Apple
- Microsoft
- Amazon
- Tesla
- Alphabet Class A
The S&P 500 was created by two men (Luther Lee & Henry Varnum Poor). It originated from their idea of discovering the credit ratings for various companies that were the best in their industries. They launched this index in the stock market to track the top 500 companies in America.
Henry Varnum Poor launched his own publishing company for investments in the railroad industry in 1860. Luther Lee began his own company called Standard Statistics Company in 1923. His company was focused on rating mortgage bonds, and he created the first stock market index. Around 1941, both Henry and Luther decided to merge and create the S&P 500. It became official in 1957 as the two men had expanded the S&P to include 500 companies in each industry. Another name is the Standard & Poor’s 500 Composite Stock Price Index.
If you are interested in locating the S&P 500 for stock market trading, the listed areas to find it are the New York Stock Exchange (NYSE) and the Nasdaq Composite. The NYSE is a stock exchange in New York that acts as an auction market with specialized professionals. By being on the auction floor, their purpose is to help companies raise funds for their business. As you probably know, purchasing a company’s stock allows the company to use that money to grow. The company’s top leadership will decide which projects your money will support to help grow their various ventures. Ultimately, a company provides stock for the public to purchase in the hopes that you will help drive them forward.
As mentioned previously, the S&P 500 includes all 11 sectors:
- Finance
- Information Technology
- Consumer Staples
- Materials
- Industrial
- Communication Services
- Healthcare
- Consumer Discretionary
- Utilities
- Real Estate
- Energy
How does the S&P 500 work?
A few criteria need to be met to join the S&P 500. The committee from the investment company called Standard & Poor is the deciders for who stays and who goes. These rules are not entirely set in stone, but this is a good guideline for how they are determined:
- Market capitalization (the total value of company shares) must be near $10 billion. How you discover if a company meets these criteria is by multiplying the stock’s current price by its total outstanding shares. For example, if Company Y was selling its stock for $20 a share and people had bought $10 million worth of the company stock, the market capitalization (aka market cap) would be $200 million. Total outstanding shares are based on the current, active amount of company stocks bought by people.
- Listed on an eligible United States stock market exchange.
- Must be in the U.S. and is a corporation that can offer common stock for people to purchase.
- The past 4 quarters (a rolling 12 months) must be reporting positive earnings. Large, stable companies have a higher probability of maintaining a positive trend vs. smaller companies that constantly fluctuate. This is why you are more likely to see large-cap or blue-chip companies.
To answer how the S&P 500 works, it is essential to understand that you cannot invest directly in this index. Like the Dow Jones index, you have to get creative with how to purchase stock in the S&P 500. There are a few options you can decide to utilize.
The first is to buy all 500 stocks from each company directly as you can then claim you are the “stock owner of the S&P 500”. For most people, this is a bit extreme and very costly. Most people will buy another index that mimics and follows the S&P 500. Popular ones are the Vanguard S&P 500 Index Investor Shares and the Fidelity 500 Index Fund, to name a few.
Like me, you’re probably thinking, why can’t you just invest directly into the S&P 500 index? Those are the stocks I want, so stop wasting my time by making me purchase a copy! The reason is that the S&P 500 is not an actual company. Hence, you have to buy a copycat index. I have no idea why they designed it that way, but unfortunately, that is how it works.
Another thing to remember about the S&P 500 is that it is measured by market-capitalization-weight (market weight). This means that the S&P 500, which has a higher value, is given more weight or power. To determine the market weight of companies in the S&P, you must divide the company’s individual market value by the total S&P market value. I will provide you an example. Let’s say that Apple has a market cap (company stock share value) of $2.866 trillion as of Dec. 2021. Then, you divide that number by the total S&P 500 market cap, which is $38.41 trillion as of Nov. 2021.
2.866 T/38.41 T = .0746 x 100% = 7.46%
That is how much weight Apple holds in the S&P 500. To put that into perspective, JP Morgan is ranked number 10 on the S&P 500. JP Morgan only has a weight value of 1.18%, compared to Apple’s 7.46%. Another example is Walmart, which was ranked number 40. Walmart’s weight value was only .52%, compared to Apple and JP Morgan. This lets you know how much power Apple has in the S&P 500. If Apple’s stock price suddenly dropped, it would swing the S&P 500 pendulum into the red line. The S&P was designed to give companies with higher values more power. This allows people to dissect the index to have a guideline for the economy’s health in America.
Let’s look at some pros and cons of the S&P 500 index.
PROS:
- It is considered an equally measured index for determining the economy’s health. Most financial & economic professionals view this index as an accurate measurement of our economy’s health.
- Compared to the Dow, this index supports all 11 sectors, which only helped 9 sectors.
CONS:
- The S&P only considers American companies and does not consider any foreign companies (based outside the U.S.). It cannot provide a global perspective of how the economy is doing.
- It does not include as many tech companies, which can be detrimental since we live in the tech area. Its counterpart, the NASDAQ, is primarily made up of tech companies with a higher market cap than companies in the S&P. It provides a more accurate perspective for that sector. Also, the NASDAQ includes foreign companies, so it has a more significant impact when diagnosing the economy globally.
- Generally, only the top companies may join the S&P 500. Companies usually need to have outstanding stock shares equal to $10 billion. As this can be a complex number to achieve, you will only find large-cap or blue-chip companies in this index. These criteria can eliminate the millions of other companies shaping America’s economy.
Moral of the story
What is the point of having the S&P 500? Since it has grown to include the “top” 500 companies in the U.S. It has cemented itself to be the most crucial index to some investors and financial professionals when determining America’s economy. It is one of the only indexes that includes all sectors and provides a wide range of companies that rank at the top in their industries. Since it is viewed as the overall benchmark for America, do not expect it to disappear for a long time. It is better to familiarize yourself with how it works and how it is viewed by many people worldwide.
This concludes my article in the Stocks 101 segment, and I hope that it was helpful to you and got you thinking more about the stock market! I always want to hear your thoughts and questions, especially about the stock market. Please email me your questions and leave comments below because I want to know what you think.
And remember, like Earl Nightingale said, “Everything begins with an idea.” See you again next time!