What Is the S&P 500 & How Does It Work?

One of the most straightforward ways to take the pulse of U.S. financial markets is the S&P 500, an index that tracks the performance of most of the biggest companies in the U.S. At a glance, the S&P 500 gives you a sense of the general health of the U.S. economy, the direction of the stock market, and which kinds of stocks are rising or falling. 

Here’s what you need to know about the S&P 500, including what it is, its history, how it works, and how you can invest in it.

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What is the S&P 500 Index?

The S&P 500, short for the Standard & Poor’s 500 Index, is a stock-market index that consists of 500 of the largest publicly traded companies operating in the U.S. The S&P 500 includes companies across 11 broad industry groups, or sectors.

The order of S&P sectors is based on market value and includes:

• Communication services
• Consumer discretionary
• Consumer staples
• Energy
• Financials
• Health care
• Industrials
• Information technology
• Materials
• Real estate
• Utilities
  

Standard & Poor’s, a major index provider, financial-data source, and credit-rating agency introduced the Composite Index, a predecessor to the S&P 500, in 1926. It had 90 stocks. In March 1957, the index was enlarged to 500 stocks and was renamed the S&P 500.

McGraw-Hill, a publishing house, acquired Standard & Poor’s Corp., owner of the S&P 500 index, in 1966. Today, the S&P 500 is maintained by S&P Dow Jones Indices—a joint venture owned by S&P Global (previously McGraw Hill Financial), CME Group, and News Corp. (the parent of Dow Jones).

How does the S&P 500 work?

The S&P 500 contains 505 common stocks (in some cases, companies have issued more than one class of shares) selected based on market capitalization, or the total value of a company’s shares outstanding. The index includes the 30 companies that make up the Dow Jones Industrial Average, and it accounts for 80% of the U.S. equity market by capitalization.

The S&P 500 does a simple calculation to establish the weighting of each company in the index, giving companies with larger market values higher percentage allocations. The formula gives the biggest company in the S&P 500, Apple Inc., with a market value of more than $2.4 trillion, an index weighting of about 5.6%, as of 2021. That means its share-price movements have a much bigger effect on the index than one of the smallest companies in the index, HollyFrontier Corp., with a market value of about $5 billion and a weighting of just 0.009%, as of 2021.  

A company’s S&P 500 weighting is calculated by dividing its market cap by the market value of all the companies in the index.

Company market cap / Total S&P 500 market cap = Company weighting in S&P 500

As of June 30, 2021, the S&P 500 total market cap was about $36.32 trillion.

The market cap of a company is calculated by multiplying the number of a company’s shares outstanding by its current stock price. For example, a company with 10 million publicly traded shares and a stock price of  $10 has a market cap, or value, of $100 million.

To be eligible for inclusion in the S&P 500, a company must:

• Be based in the U.S., with a significant share of its fixed assets and revenues in the U.S. However, some companies domiciled in overseas tax jurisdictions are considered American for listing purposes.
• Have an unadjusted market cap of at least $13.1 billion.
• Be highly liquid, meaning its shares can be easily traded.
• Make at least 50% of its stock available for public trading and be listed on a major exchange such as the New York Stock Exchange, or one of the Nasdaq or Cboe exchanges.
• File a 10-K annual report.
• Have positive total net income in the four most recent quarters.  
  

As of June 30, 2021, Top 10 Constituents by Index Weight:
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The data above comes from S&P Dow Jones Indices. 

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S&P 500 historical returns

Since the late 19th century, the S&P 500 has delivered 10-year average annual returns of 9.2%, according to Goldman Sachs data. Between 2010 and 2020, however, the S&P 500 outperformed, with an annual average return of 13.6%.

How inflation affects the S&P 500

When adjusted for inflation, which tends to erode the value of financial assets, the S&P 500’s historical average annual return is about 7%. Some investors doubt that this inflation-adjusted figure is accurate because it’s based on figures from the Consumer Price Index, or CPI, which some analysts say tends to understate rising prices.

Although the effects of inflation vary from sector to sector, unexpected inflation can reduce returns by:

• Increasing input costs, such as materials and labor;
• Raising borrowing costs; and
• Reducing expectations for earnings growth.

The S&P 500 vs. other stock market indexes

The S&P is one of several equity indexes used to measure the performance of the U.S. stock market. Other indexes include the Dow Jones, Nasdaq Composite, and the Russell 2000, among others.

Here’s how the S&P compares to two of the most widely followed stock indexes.

S&P 500 vs. Nasdaq

The National Association of Securities Dealers, now known as the Financial Industry Regulatory Authority, or FINRA, introduced the Nasdaq Composite Index in 1971 with a value of 100.

This index, like the S&P, uses a market-cap-weighting formula to gauge where particular stocks land within the index. To be included in the Nasdaq, a stock must be traded only on the Nasdaq Stock Exchange.

The Nasdaq tracks nearly 3,000 companies. It contains a high concentration of tech companies, because its listing fees are lower and it has less stringent profitability requirements. The Nasdaq also includes a few foreign companies.  

S&P 500 vs. Dow Jones

Although the Dow is the most quoted -- and the second-oldest -- active stock index in the world, it only consists of 30 stocks, making it less representative of the economy or broader stock market than the S&P 500.

Unlike the S&P 500, the Dow is price weighted, not market-cap weighted. This means that companies with higher share prices will have a greater impact on the index, regardless of their valuations.

To calculate the value of the Dow, investors add the share prices of all 30 companies and then divide that number by the Dow Divisor. The Dow Divisor is a figure that’s adjusted for a number of events, including stock splits and dividend payments.

How to invest in the S&P 500

You can’t invest directly in the S&P 500, or any other index, because they aren’t companies with publicly traded shares. You can, however, buy shares of stocks listed in the S&P 500, or purchase shares of a mutual fund or an exchange-traded fund (ETF) that passively tracks the S&P 500. 

A few of the top S&P index funds include: 

• Fidelity 500 Index Fund (FXAIX)
• Vanguard 500 Index Investor Shares (VFINX) 
• Schwab S&P 500 Index Fund (SWPPX) 

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How to invest in the S&P 500 as a DIY Investor

If you’re a hands-on investor who prefers to choose your own securities, you can do so with an online brokerage account. These platforms give you the opportunity to invest in stocks, mutual funds, and ETFs.

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