When the average person talks about the stock market, chances
are that person is referring to the
Composed of the biggest and best companies in the United
States, this marquee index is one of the most widely cited and
tracked economic benchmarks ever invented. Not only is it
considered a leading indicator of future economic activity, but
it's also the arbiter of personal wealth for many Americans whose
retirement savings are pegged to it in one fashion or
It's for these reasons that the S&P 500 is referenced
everywhere. The previous day's closing level is quoted on the
front page of newspapers. Evening news programs cite it. And
legions of financial professionals, particularly money managers,
use the index to gauge their own performance, as well as that of
What is the S&P 500?
While it may not seem like it now, the creation of an index to
track stock values was at one time a revolutionary concept. The
predecessor to the S&P 500 was initiated in 1923, when a
company named Standard Statistics developed the first "widely
published capitalization weighted index in the United States,"
covering 233 U.S.-based companies. It was expanded to include 500
companies in 1957.
In its current form, the S&P 500 is an index of large-cap
stocks -- each with a market capitalization of $5.3 billion or
more -- that are based in the United States and trade on
either the New York Stock Exchange or the Nasdaq. In short, it
tracks the share prices of the 500 largest and most profitable
publicly traded companies in America.
Its components run the gamut of business models, sectors, and
industries. On one end of the continuum is
, the innovative tech company behind the iPhone, the iPad, and
iTunes. On the other end is the
Apartment Investment and Management Company
, a real estate investment trust that "engages in the
acquisition, ownership, management, and redevelopment of
How big is the S&P 500?
To describe the S&P 500 as "big" doesn't do it justice. In
addition to being the most widely followed equity index in the
U.S., it's arguably the best-known economic indicator in the
world. According to Standard & Poor's, more than $5.14
trillion is benchmarked to the index via exchange-traded funds
and other investment vehicles designed to mimic the broader
On top of this, even though the index tracks only 500 stocks
out of the thousands that trade on U.S. exchanges, it captures
about 80% of all available market capitalization -- which is why
it's regarded as one of the best indicators of the broader U.S.
How does the S&P 500 work?
Multiple companies are added to and subtracted from the
S&P 500 every year. In 2013,
, Dell, and
Abercrombie & Fitch
, among others, were stripped of the coveted designation and
Alliance Data Systems
The Standard & Poor's U.S. Index Committee is responsible
for deciding which companies should be included in the index, and
its decision is guided by five requirements:
- Its market capitalization must exceed $5.3 billion.
- Its stock must be sufficiently liquid.
- It must be domiciled in the U.S.
- At least 50% of its shares must be available for trading by
the general public.
- It must be financially viable -- that is, "the sum of the
most recent four consecutive quarters' as-reported earnings
should be positive."
Once on the index, a company is accorded a weighting
commensurate with its market capitalization. The bigger the
company, the bigger the influence. On the high end are stocks
such as Apple,
Johnson & Johnson
, which command a cumulative weighting of nearly 10%. Meanwhile,
companies such as
barely register on the scale, with individual weightings of 0.02%
What drives the S&P 500?
Since mounting an unprecedented ascent in the aftermath of
World War II, the S&P 500 has delivered extraordinary
returns. At the beginning of 1950, the index value was a mere 17.
Halfway through 2014, the index was near 2,000. That equates to a
return of roughly 11,000%,
In hindsight, it's clear that two forces fueled this
remarkable performance -- and, for the record, these continue to
exert the same influence on the S&P 500 today. First, it's an
axiom in investing that the interest rate on risk-free government
bonds is inversely correlated to the price of all other
investments, including stocks. So, because interest rates have
been on a gradual decline for more than three decades, the stock
market has responded by moving higher.
And secondly, rising corporate profits -- both on an absolute
basis and as a percentage of gross domestic product -- have also
had a positive influence on equity levels. In the 1950s,
corporate earnings were anywhere between 5% and 7% of U.S. GDP.
The same figure nowadays is in the neighborhood of 10%, even as
GDP has grown from less than $500 billion to more than $15
trillion over the same time period.
The bottom line on the S&P 500
When it comes to investing, it's hard to deny the core role of
the S&P 500. It's the backbone of the American equities
markets and has long given retail investors the opportunity to
participate in the growth of both domestic corporations and the
broader economy. Will it continue to do so going forward? In
short, there's little reason to believe that it won't.
S&P 500: Investing Essentials
originally appeared on Fool.com.
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