What Is The S&P 500 Index & Should You Invest In It?

Many people struggle financially due to the rising inflation in the countries where they live. And so, they are seeking new ways to upgrade and boost their finances.

Although investment is a popular term, many people don't know how it works. They need to be educated on where or how to invest.

This is where the S&P 500 index comes in.

Stick around to find out what it is and the pros and cons of investing in the index.

S&P 500

The S&P 500 index stands for Standard & Poor’s 500 Index: it is a market-capitalization index that tracks the 500 leading publicly traded companies in the United States.

The index differs from the list of the top 500 U.S. companies by market capitalization because other things are used to determine the list.

But, the S&P remains the most popular gauge of prominent American companies’ stock performance and the stock market in general.

The index began in 1957 by the credit rating agency Standard and Poor's.

The S&P 500 is float-weighted, which implies the number of stocks available for public trading adjusts the market capitalization of the companies listed in the index.

So why is the S&P 500 index so important to potential investors?

Number 1: It Acts As The Market Indicator.

First, the S&P 500 is crucial because of its capacity to work as an indicator of the state of the general market and a benchmark for several investors.

It is also considered the best way to measure large capitalized U.S. stocks.

Since it accounts for nearly 80% of the total market capitalization of all stocks in the United States and reflects the performance of many industries within the American economy, it’s a beneficial tool for investors to keep track of which direction the economy as a whole is going.

Number 2: It Measures Company’s Performance.

The index also benefits the companies because it is an essential barometer for those looking to measure their performance relative to competitors.

It plays a vital role in how investors invest their funds.

Therefore, analysts use it to predict the stock market or recommend the stock to buy or sell.

So, every investor should keep a close eye on the index. It is the most common way to study the stock market and companies within it.

Limitations

However, the S&P 500 is not without its own set of limitations.

Since the index is market cap weighted, companies with higher market capitalization have more clout. Therefore, there are cases of disproportionate weighting to the bigger companies.

Hence, these outsized weightings can impact the performance of the index.

One of the effects of weightings is a handful of stocks driving the index's overall performance. But, it is difficult to know this limitation by looking at the index's total performance, which is why it can sometimes be misleading.

For example, Apple and Microsoft account for over 11% of the benchmark.

These companies create anomalies as other less prominent companies can get lost in the index.

In addition, the S&P 500 only has companies situated in America.

So, popular foreign stocks, including ones in China or Germany, are excluded from the index and would need help to figure out their performance, which makes the index less of an indicator of the global economic trends.

Despite its limitations, the S&P 500 remains an excellent economic indicator for those in the United States and those outside America who want to invest in U.S. stocks.

How it works

Having seen the advantages and limitations of the main index, it is time to see how the S&P 500 works.

This section is one which is less frequently talked about, as people generally don’t care, however it is important to understand how it works in order to maximize the benefits that you can get.

The index measures the performance of the best 500 corporations in America. The index uses an independent panel of financial analysts to evaluate these corporations and their stocks.

Analysts consider revenue growth, dividends paid to shareholders, liquidity ratio, volatility, and profitability.

When these factors are analyzed, the index grants each company one of three ratings:

A (strong buy)
B (buy)
C (hold)

The S&P 500 includes companies with higher ratings. Ratings from the S&P 500 are released every three months.

The index ranks each company’s weight based on the amount of money it is worth in relation to other companies considered by the index.

And that is why larger companies with bigger market capitalization considerably impact the index performance more than those with smaller market capitalization.

The parameters analysts use to determine the index ensure that only the most resilient companies are added to the S&P 500 index.

The S&P 500 chart shows how the index has progressed over a particular period. Analysts mostly use it to assess market performance and make informed investment decisions.

Other comparable indexes

Although the S&P 500 is considered the most accurate stock market indicator by most people, other indexes are used by financial analysts.

Dow Jones Industrial Average

An example is the Dow Jones Industrial Average. Dow Jones, one of the oldest indexes, tracks 30 leading companies in the U.S.

Also, it is a price-weighted index, unlike the S&P 500.

This means it uses the price per share for each stock included and divides the sum by a common divisor, usually the total number of stocks in the index.

One limitation of the Dow Jones Industrial Average is that the list of companies is too few.

In addition, it may unfairly penalize a company with a stock split.

Russell 3000 Index

The Russell 3000 Index is another one that people consider as an alternative to the S&P 500.

This takes into account the 3,000 largest U.S-based corporations, which represent about 97% of all U.S.-incorporated equity securities.

Many hedge fund managers like the Russell 3000 index more as it covers a larger percentage of the total investable securities in the US.

Nasdaq-100

The Nasdaq-100 is another main index applied to companies in the stock market.

It includes the 100 largest domestic and foreign non-financial corporations on the Nasdaq stock market.

So, you won’t be seeing any commercial or investment banks like JPMorgan or Goldman Sachs listed in the Nasdaq 100 index.

Over the years, the index has remained relevant, and at times outperformed the S&P 500, because of its priority in the technology sector, one of America's fastest-growing sectors.

Think Apple, Microsoft, Google, Meta and Amazon.

However, its parameters are narrower than the S&P 500, so it can put your investment at risk when a downtown happens in the technology sector like what is happening right now.

So, it can be better to focus on indexes that are more diversified, especially if you are new to stocks or are more risk averse.

Its popularity

The popularity of the S&P 500 makes many people want to invest in it.

However, that won't be possible as you won’t be able to invest directly in an index, unlike a stock.

Nonetheless, most leading brokerage firms offer exchange traded funds or ETFs that track the holdings within the S&P 500 index, including Fidelity and Vanguard, alongside online trading platforms such as Robinhood and Stash.

The Index funds act as a proxy, which mimics the performance of all the companies in the S&P 500 index.

Thereafter, investors’ money are pooled together to buy the companies that are in the index apportioned based on each of the holding’s weightage.

This is what’s known as a passively-managed fund, where the fund managers do not make active decisions in which stocks to include or exclude, instead they simply aim to copy the S&P 500 index’s make-up and performance.

And when the holdings differ too much from the index, the fund manager would rebalance the index periodically, usually once a quarter.

Let’s say you want to invest in the S&P 500 index funds.

Knowing the types and differences between mutual funds and exchange-traded funds is important.

The main difference is that mutual funds shares are priced and traded only at the end of the day, while you can trade exchange-traded funds throughout the day.

In addition, you will need more money to invest in mutual funds as there is usually a hefty minimum investment before you can start to invest.

In contrast, exchange-traded funds shares are priced similarly to single stock shares, and are traded in the stock exchange.

Therefore, you can buy as many or as little as you want, depending on how much money you have to invest.

Variations of the S&P 500

A quick search in the market will show you plenty of index funds tracking the S&P 500 index.

And with each fund differing slightly in their make-up and strategy.

For example, the Vanguard S&P 500 Growth ETF focuses on growth-oriented corporations listed in the S&P 500.

Analysts expect stocks of corporations under the category to appreciate faster than your conventional stocks.

Alternatively, the Invesco S&P 500 high-dividend low volatility ETF emphasizes stocks that pay strong dividends to investors.

But they track the same index, so the results are more or less identical.

What you should be focusing on instead are things like their expense ratios and other hidden fees, since these can affect your returns by a wide margin over the long term.

So what you can do is just look for a low cost fund such as VOO or CSPX depending on your region and stick to it.

Main questions to answer

Now, we want to answer your main question since the beginning of the video:

should I invest in the S&P 500 index?

We told you earlier that you can’t directly invest in the S&P 500 index, but you can invest in ETFs that track the performance of the S&P 500 index.

Some key points for you to quickly decide whether it is worth it for you:

The S&P 500 index fund often relates closely to the broad US market, so it is better than many other indexes, such as the Russell and Dow Jones Industrial Average. For instance in 2020, the Dow Jones climbed only 7.2%, while the S&P 500 gained approximately 16% the same year.
It is highly diversified which makes it a low risk option for both short term and long term plays. Their securities represent a range of industries. Corporations within the index are a mix of growth and value companies, such as Apple, Netflix, Visa, Johnson and Johnson, and Procter & Gamble.
And finally the downside is you won’t be beating the market, because the most you can do is keep up with it, which is not as bad as you might think.

Now that is the end of the article, are you convinced to start investing in the S&P 500?

Or are you more determined now if you already owned some ETFs that track the index?

- Ivan