What is the S&P 500 and How Do I Trade It?

Wed Feb 10, 2021, 01:05 pm | by Dan Schmidt | No comments

When your TV is on CNBC or Bloomberg, you’ll almost always see a little box in the lower right-hand corner tracking the daily progress of the big three American indices – the Dow Jones Industrial Average, the S&P 500, and the NASDAQ Composite. When people talk about the stock market, they’re referring to the companies that compose the basis of these indices. The Dow is the oldest and smallest of the three, while the NASDAQ is the newest and lists thousands of companies.

The S&P 500 is right in the middle through, an index tracking the stocks of the largest and most successful American companies. The company list may change over time, but the index has long been the gold standard for stock market tracking and analysis. But where exactly does the S&P 500 come from and what is it attempting to measure? Why is it called the S&P 500 if it actually contains 505 stocks? Those questions and more will be answered in this post, so read on if you want to learn how to trade the S&P 500.

What is the S&P 500?

The S&P 500 is a stock market index developed by Standard Statistics Company back in 1923. Called the ‘Composite Index’, it tracked the price movements of more than 200 publicly-traded US stocks. Standard Statistics merged with Poor Publishing to form Standard and Poor’s, which today operates as one of the world’s largest global credit rating agencies. 

In 1957, the index was expanded to include 500 companies and was renamed the S&P 500 index. Today, the S&P 500 is one of the most widely quoted stock indices on the planet and most market professionals use it as a proxy for the entire US stock market. The index contains the 500 largest US companies by market capitalization, meaning the combined value of all outstanding shares. Since five companies in the index have two different classes of shares available to trade, the index actually contains 505 different stocks.

What Companies Qualify for the S&P 500?

The constituents of the S&P 500 aren’t automatically selected. Each quarter, a committee will meet and decide if the companies in the index need to be removed or rearranged. Since the index is weighted by market capitalization, the largest companies hold the most sway over. 

In order to be selected for inclusion in the index, stocks might meet a certain set of criteria. Even if all criteria are met, inclusion in the index is not guaranteed. In order to be considered, a stock must have the following qualifications:

  • Market cap of at least $8.2 billion
  • Share value of at least $1
  • Minimum monthly trading volume of at least 250,000 shares
  • Must be US-based.
  • Must trade on either the New York Stock Exchange (NYSE) or NASDAQ
  • Several types of securities and shares classes are excluded, such as preferred stock, ETFs, ETNs, Limited Partnerships, ADRs, or OTC stocks.

In the most recent example of changes, Tesla (NSDQ: TSLA) was added to the index while Apartment Investment and Management Company (NYSE: AIV) was removed. Currently, the top 10 stocks by weight in the S&P 500 are:

  1. Apple Inc (NYSE: AAPL)
  2. Microsoft Corp. (NYSE: MSFT)
  3. Amazon Inc (NYSE: AMZN)
  4. Facebook Inc (NYSE: FB)
  5. Tesla Inc (NYSE: TSLA)
  6. Alphabet Class A (NYSE: GOOG)
  7. Alphabet Class C (NYSE: GOOGL)
  8. Berkshire Hathaway (NYSE: BRK.B)
  9. Johnson and Johnson (NYSE: JNJ)
  10. JPMorgan Chase (NYSE: JPM)

Can I Trade the S&P 500?

The S&P 500 isn’t a security like a stock or a bond and you can’t buy it from a brokerage. An index like the S&P 500 is simply a tool used to gauge the progress of its member stocks as a whole. But while we can’t buy the S&P 500 itself, we can use proxies to mimic its movements.

ETFs like SPY and mutual funds like the Vanguard 500 Index are designed to imitate the movements of the S&P 500 by holding shares of companies based on their weights in the index. It’s not an exact mimicry of the gyrations of the index, but it gets pretty close. Mutual funds and ETFs tracking the S&P 500 rebalance their portfolios as the index adjusts the weight it gives each individual company. 

Tracking indices like the S&P 500 is the thought process behind index funds, which don’t seek outperformance but simply to match the returns of the overall market. Hundreds of ETFs track the S&P 500 index in some form or another, each with various methods and weights (and expense ratios, of course). Additionally, more aggressive traders can invest in the S&P 500 through the options and futures markets. 

How Does the S&P 500 Differ from the Dow Jones Industrial Average?

The Dow Jones Industrial Average (DJIA) is one of the oldest stock indices around, predating the original iteration of the S&P 500 by nearly 30 years. But there are some key differences between the two that investors should be aware of.

For starters, the DJIA contains only 30 stocks. These stocks are selected based on their industry and size, but there are only 30 components total compared to the 505 stocks in the S&P. Additionally, the DJIA is weighted by price, not market cap. A price-weighted index uses the total value of all constituent stock prices in order to calculate its total. This is different than the S&P 500, which uses the combined market cap of its constituents in its calculation.

Which one is better? Both indices have provided similar returns over the last 5 years, but the S&P 500 provides a broader range of exposure to US companies. Additionally, a market cap-weighted index of 505 individual stocks should (at least in theory) be less volatile than a price-weighted index of 30 stocks.

Cons of the S&P 500

Buying index funds that track the S&P 500 is solid investment advice that has been recommended by finance legends like Warren Buffett and John Bogle. The S&P 500 is reliable, affordable, and easily accessed by retail investors. But it’s by no means a perfect investment. Here are a few criticisms of the S&P 500:

  • No Small Caps – By limiting inclusion to only the 500 most qualified stocks, small cap stocks are left out of the equation. Historically, small cap stocks have provided the best returns over time.
  • Average Returns – When you invest in the S&P 500, you’re investing in the larger US stock market as a whole. This means you have a little piece of 500 different pies, but only a little piece. If you want returns that beat the market, you’ll need to concentrate your capital in a smaller number of stocks, which obviously involves more risk.
  • Top Heavy – The top 10 stocks in the index comprise more than 50% of its total weight, meaning performance is really guided by a handful of companies.

Final Thoughts

The S&P 500 is the backbone of many retirement plans and investment portfolios because it’s a low cost, highly-liquid way of gaining exposure to the best of the US stock market. The S&P 500 is used as a proxy for many of the most popular investment vehicles, like the Vanguard 500 mutual fund or the Standard and Poor 500 ETF from State Street Advisors (NYSE: SPY). 

If you want to invest in the S&P 500, you’ll have no shortage of options. Since many of the investment vehicles track the index in similar fashion, be sure to use low cost index funds to keep expenses down. And remember the limitations of index investing – you’re going for the basic market return. If you’re expecting quick wealth by investing in the S&P 500, you’ll probably find yourself disappointed.