Investors and traders alike like to have a benchmark to tell them how the stock market is doing overall as well as how they are doing with their investments and trades. While a number of these benchmarks exist, perhaps none is more watched and respected than the Standard & Poor's 500 index (S&P 500).
The S&P 500 is an index of 500 large cap stocks selected by analysts and economists and designed to reflect the large cap market. Other S&P indexes include small cap and mid cap companies respectively.
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The S&P 500 uses a market cap weighting – as opposed to the price weighting used by the Dow Jones industrial average (DJIA). The market cap ranking is believed to be more representative of the structure of the stock market.
It would be next to impossible for the average investor to duplicate the S&P 500 – owning stocks of 500 companies could get very expensive – so most investors purchase shares of mutual funds or ETFs that seek to replicate the index in one way or the other.
How The S&P 500 Works
The S&P 500 captures 80% of the total market cap of the entire stock market, which makes it reflective of the market as well as relevant. Companies in the S&P 500 are in the U.S. and have a market cap of at least $5.3 billion. In addition, at least 50% of the company’s stock must be available to the public and the stock price must be at least $1 per share. Finally, it must have at least 4 consecutive quarters of positive earnings.
The makeup of the index reflects that of the economy. For example, in 2017 sector percentages are: IT (23.2%), health care (13.9%) percent), financials (13.7%), consumer discretionary (12.5%), consumer staples (9.4%), utilities (3.3%), materials (2.8%), and telecom services (2.2%).
In 2017, the 10 largest companies in the S&P 500 are Apple Inc. (NASDAQ:AAPLC), Microsoft Corp. (NASDAQ:MSFTC), Amazon.com Inc. (NASDAQ:AMZNB), Facebook Inc. (NASDAQ:FBC), Johnson & Johnson (NYSE:JNJD), Exxon Mobil Corp. (NYSE:XOMC), Berkshire Hathaway Inc. (NYSE: BRK.B), JPMorgan Chase & Co. (NYSE:JPMC), Alphabet A (NASDAQ:GOOGLC) and Alphabet C (formerly Google) (NASDAQ:GOOGC).
Mistakes You Can MakeIf you use the S&P 500 as a benchmark you need to be careful about making some of these common mistakes:
Ignoring friction – The S&P 500 index benchmark is impossible to achieve. It’s purely theoretical because it ignores trading fees, bid-ask spreads, liquidity and many other factors.
Failing to allow for dividends – Dividends add significantly to the overall total return of the S&P 500. The pure S&P index change excludes dividends which lowers returns and makes performance look better than it is.
Forgetting about taxes – Capital gains taxes vary greatly from individual to individual. Do not compare your real after-tax returns with the S&P benchmark pretax returns.
Missing size and scope – The S&P 500 is only 500 domestic companies. True, it covers 80% of the U.S. equity market, but it is not the whole market. Just saying.
Forgetting the rest of the world – The S&P 500 represents only the U.S. equity market. Although U.S. companies are still the most important in the world, they only make up about 1/3 of the total world market cap.
Failing to view your entire portfolio – The S&P 500 is a good benchmark for stocks or stock funds/ETFs. It may not be so good for bonds, REITs and other non-stock assets. Don’t compare your entire portfolio to the S&P 500. It’s not apples to apples.