Before we talk about the S&P 500, let’s look at some other stock market terms that will help us to understand the S&P 500.
What is an index fund?
An index fund is a portfolio with a bunch of stocks. Instead of investing in one stock or some particularly chosen stocks, the individual invests in a bunch of stocks- all the stocks that are in the fund. The idea is that the growth or decline of an index fund matches that of the market.
What is market capitalization?
Market capitalization (aka market cap) shows the total value of a company in the stock market.
Market cap of a company = price per share times the total number of shares
The market cap of a company equals the price per share times the total number of shares. For example, if a company has 1 million shares each worth 10 dollars, the company has a market cap of 10 million dollars.
The different categories of market cap:
Small-cap companies have a market cap between $300 million and $2 billion. They are high risk, but have a potentially high reward since they have a lot of growth potential.
Mid-cap companies have a market cap between $2 billion and $10 billion.
Large-cap companies have a market cap above $10 billion. They are more stable in rough markets, which makes them less risky, but they have less growth potential.
What is the S&P 500?
Often used as a benchmark for the movement of the overall market, the S&P 500 is an index fund. Run by Standard & Poors (S&P is short for Standard & Poors), the S&P 500 measures the movement of 500 large, publicly-traded companies based in the US.
The S&P 500 “is not an exact list of the top 500 U.S. companies by market capitalization, because there are other criteria to be included in the index.” Put another way, the S&P 500 isn’t a list of the 500 companies with the largest market cap, because there are other criteria that a company needs to meet to be put in the index.
Other criteria for a company to be in the S&P 500:
Have a market cap of at least $8.2 billion
Be based in the U.S.
Have turned a profit for the last 12 months at any given point
Have at least half of their shares publicly traded
Be structured as a corporation
Be liquid- the company’s short term assets, like cash, must cover its short term liabilities, like debt.
The company must be on one of the following stock exchanges: the New York Stock Exchange, Investors' Exchange, Nasdaq, or BATS Global Markets. It cannot be traded over the counter or listed on pink sheets.
What is market cap weighting?
The S&P 500 is a cap-weighted index. This means that a company’s market cap determines how much of an impact that company’s stock has on the overall index.
A company’s weight in the index = Market cap of that company Total market cap in the index
To better understand market cap weighting, imagine an index of 5 companies:
Company A: 1 million shares, $45 per share currently
Company B: 300,000 shares, $125 per share currently
Company C: 500,000 shares, $60 per share currently
Company D: 1.5 million shares, $75 per share currently
Company E: 1.5 million shares, $5 per share currently
First, calculate the market cap of each company:
Company A’s market cap = 1 million * $45 = $45 million
Company B’s market cap = 300,000 * $125 = $37.5 million
Company C’s market cap = 500,000 * $60 = $30 million
Company D’s market cap = 1.5 million * $75 = $112.5 million
Company E’s market cap = 1.5 million * $5 = $7.5 million
Then, calculate the total market cap of the index:
Total market cap = $45 million + $37.5 million + $30 million + $112.5 million + $7.5 million = $232.5 million
Finally, calculate the weight of each company:
Company A’s weight = ($45 million / 232.5 million) * 100 = 19.4%
Company B’s weight = ($37.5 million / 232.5 million)*100 = 16.1%
Company C’s weight = ($30 million / 232.5 million)*100 = 12.9%
Company D’s weight = (112.5 million / 232.5 million)*100 = 48.4%
Company E’s weight = ($7.5 million / 232.5 million)*100 = 3.2%
As of November 2nd, 2020, the ten largest stocks in the S&P 500 made up around 28% of its value. Apple, the company with the highest market cap in the S&P 500, has a weight of 6.5%. To put this in perspective, if all the stocks in the S&P 500 were evenly weighted, they would all have a weight of 0.2%.
Why is the S&P 500 so prestigious?
Investors often use the S&P 500 “as the benchmark of the overall market.” Often, the growth or decline of investments is compared to the growth or decline of the S&P 500.
When a company is part of the S&P 500, the company usually benefits. Its stock “will be added to indexed investment funds (mutual funds and exchange-traded funds).” When an investor is bullish on the overall stock market (thinks that the overall stock market will go up), they will often buy indexed investment funds, which will help the companies that are in the index. For example, it was widely thought that Tesla (TSLA) would be added to the S&P 500. It met all the criteria, has a market cap of 330 billion, and is becoming a leader in the auto industry. However, it was not added to the S&P 500, which, in part, caused a 15% drop in Tesla stock over the course of one day.
Data Sheet: Statistics about the S&P 500
Here’s the growth of the S&P 500 over the last 5 years:
And here’s the growth of the S&P 500 since it was founded on March 4th, 1957:
The 10 Largest Companies (by market cap) in the S&P 500 (as of November 2nd, 2020):
Apple Inc. (AAPL) -- Index weighting: 6.5%
Microsoft Corp. (MSFT) -- Index weighting: 5.7%
Amazon.com Inc. (AMZN) -- Index weighting: 4.8%
Facebook Inc. (FB) -- Index weighting: 2.3%
Alphabet Inc. Class A Shares (GOOGL) -- Index weighting: 1.8%
Alphabet Inc. Class C Shares (GOOG) -- Index weighting: 1.8%
Berkshire Hathaway Inc. (BRK.B) -- Index weighting: 1.5%
Johnson & Johnson (JNJ) -- Index weighting: 1.3%
Procter & Gamble -- Index weighting: 1.3%
Nvidia Corp. -- index weighting: 1.1%
The Weight of Different Industries in the S&P 500 (as of August 31st, 2020):
Information technology: 27.5%
Health care: 14.6%
Consumer Discretionary: 11.2%
Communication Services: 10.9%
Financials: 9.9%
Industrials: 7.9%
Consumer Staples: 7.0%
Utilities: 3.1%
Real Estate: 2.8%
Materials: 2.6%
Energy: 2.5%
Warren Buffett’s Famous Index Fund Bet
In 2008, Warren Buffett and Protégé Partners LLC, a hedge fund, placed a million-dollar bet. Buffett’s (correct) contention was that: “an S&P 500 index fund would outperform a hand-picked portfolio of hedge funds over 10 years.” While the S&P 500 is an index fund that follows the market, the hedge fund invests in specific stocks, thinking that these specific stocks will do better than the overall market. After 9 years, the hedge funds had an average return of 22.0%. The S&P 500 index fund that Buffett invested in had a return of 85.4%. Buffett, and the S&P 500 index fund, had clearly won.
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