What Is the S&P 500 Index and How Does it Work?

Here's what the S&P 500 index is, how it works and what companies it includes.

The Standard & Poor’s 500 index is a collection of U.S. equities across a broad range of industries. The VanguardS&P 500 index fund, one of the most popular ways to invest in the index, holds more than $500 billion in investor funds, a testament to its success.

Although most investors likely know that the S&P 500 is one of the major market averages, many might not fully understand what the S&P 500 actually is or how it is created and maintained. Here’s everything you should know about investing in the S&P 500 index.

1. It’s a Financial Services Company

Standard and Poor’s is an American financial services company. Commonly referred to as S&P, the company provides investors and institutions with financial data and analytical information on global markets. The S&P 500 is one of a handful of indexes developed by a division of the company known as the S&P Dow Jones Indices. The intent of the index is to reflect the performance of the broad economy.

2. A Stock Index Represents a Segment of the Market

A stock index is a collection of stocks meant to represent a certain segment of the overall market. Countless stock market indexes exist, tracking everything from oil stocks to transportation businesses to small, medium and large companies. Each index consists of common stocks from the particular industry or market group the index represents.

3. It’s a Proxy for the Overall Market

The stocks in the S&P 500 represent 80 percent of the total value, or market capitalization, of the entire U.S. stock market. As a result, the S&P 500 is essentially a proxy for the overall market. The S&P 500, however, is strictly a stock market index for giant companies. To even qualify for inclusion, a company must have a market capitalization of more than $2.5 billion; the median market cap is more than $19.5 billion.

Read This: 20 Things to Do in a Falling Stock Market

4. It Has Some of the Most Recognizable Brand Names

The largest stocks in the S&P 500 index include some of the most recognizable name brands and companies in the world. Ranked in terms of market capitalization, the 10 largest companies in the S&P 500 index are:

  • Apple
  • Microsoft
  • ExxonMobil
  • Amazon
  • Berkshire Hathaway
  • Johnson & Johnson
  • Facebook
  • JPMorgan Chase and Co.
  • General Electric
  • AT&T Inc.

Check Out: 15 Stocks Warren Buffett Is Investing a Ton of Money In

5. Price Is Determined By Weighted Average Market Capitalization

The price of the S&P 500 is determined through a process known as weighted average market capitalization. Market capitalization is calculated by multiplying the shares a company has outstanding times the current market price. For example, if a company has 10 million shares in existence and a $45 share price, its market capitalization is $450 million.

To get a weighted average market capitalization, this figure is multiplied by the percentage weight a company has in the index. For example, if the entire S&P 500 is worth $10 billion and one stock has a market cap of $100 million, it has a 1 percent weight in the average.

6. It Goes Back to 1957

The index was created on March 4, 1957, so charts can go back only to this date. To read a stock chart, you can typically select the time period over which you want to view the S&P 500’s performance. An S&P chart shows the performance of the index over a specific period of time. The price of the index is listed on the vertical section of the chart and the date is posted along the horizontal section.

7. You Can Track Historical Returns

Investors have put more than $2.2 trillion into S&P 500 index funds designed to track the return of the actual S&P 500 index, so there’s no shortage of performance reports available. You can track the S&P 500 index over nearly any time frame, from decades-long periods to minute-by-minute snapshots.

Regulatory institutions such as the Securities and Exchange Commission recommend investors take a long-term approach to S&P performance rather than engage in stock trading because day-to-day stock market returns can vary wildly.

See: 15 Stocks for Beginners to Try in 2018

8. It Consists Solely of Large Cap Stocks

The S&P 500 index consists solely of large-cap stocks. Beyond that classification, however, it does not adhere to one particular investment style. Value stocks typically pay a dividend and have a low valuation, whereas growth stocks often have high valuations and pay no dividends. You will find both types of stocks represented in the S&P 500 index.

9. Futures Trade Even After the Market Closes

S&P 500 futures give investors the right to buy the stocks in the S&P 500 at a specified price at a future date. Futures might predict expectations for future stock market prices, and they continue trading even after the stock market closes, so they’re often used as an indicator as to whether the S&P 500 index will trade up or down on the next trading day.

10. Stocks Trade on Nasdaq and the NYSE

The New York Stock Exchange and Nasdaq market are the two largest stock exchanges in the United States. Stocks in the S&P 500 index come from both the NYSE and the Nasdaq.

11. Annual Returns Have Averaged 11.42%

From 1928 to 2016, the S&P 500 annual returns have averaged 11.42 percent. This rate compares favorably with the 10-year U.S. Treasury bond return of 5.18 percent per year over the same time period. Over the long term, stocks provide the highest average performance among major asset classes.

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