What Is the S&P 500, and How Does It Work?

What Is the S&P 500, and How Does It Work?

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The S&P 500 is famous in the financial industry. In fact, even outside the financial industry, most people have heard of the S&P 500. But, what actually is it? How does it work? Why does it matter? I’ll answer these questions and more in the rest of this article, so buckle up! It’s actually more interesting than you might expect!

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The S&P 500, a Brief History:

In 1860, Henry Varnum Poor first published History of Railroads and Canals in the United States. Sound boring? Maybe. But, this book held financial and operational information about every U.S. railroad company. Considering railroad companies were big business back then, this kind of information was important. In fact, 9 years after the first edition of this book, the first transcontinental railroad was born. Poor was onto something.

Later, in 1906, Luther Lee Blake founded Standard Statistics Bureau, which provided financial information on all non-railroad companies. He approached this differently than Poor. Instead of publishing an annual book, he released his information on 5″ x 7″ index cards. This allowed them to update the information more often.

Since together Poor and Blake covered everything both railroad and non-railroad, they were clearly a match made in heaven. In 1941, the two companies merged together, creating Standard & Poor’s Corp.

If you hadn’t guessed already, the “S” and “P” in S&P stand for Standard and Poor, but where did the 500 come from? The 500 stands for the 500 large, American, publicly traded companies that make up the index. The index itself started with just a few stocks in 1923. The index had 90 stocks in 1926, and the 500 we know and love today started in 1957.

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How Are Companies Selected in the S&P 500?

Unlike some indexes which select their stocks based on a set of rules, a committee decides which companies represent the S&P 500. For this reason, the S&P 500 does not contain the largest 500 companies, but rather 500 large, committee-selected companies. The committee considers the following factors when choosing to add or remove a company:

  • market capitalization (minimum market cap of $5.3 billion)
  • Liquidity (annually traded market capitalization)
  • Domicile (headquartered in U.S.)
  • Public float (public holds at least half of all shares)
  • sector classification (accurately represents its industry sector)
  • financial viability (four straight quarters of positive as-reported earnings)
  • length of time publicly traded (at least six months since IPO)
  • Stock Exchange (shares must trade on either NYSE or NASDAQ)

Because of these strict requirements, the committee adds and drops companies from the index every year. Usually at least 10 companies switch out every year, and the committee can do this at any time. Keep in mind, this kind of switch doesn’t always mean the dropped company is bad. Sometimes, there’s just a better one they might want to add.

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How Do They Calculate the S&P 500?

You can calculate the value of the S&P 500 index by dividing the adjusted market capitalization by a proprietary divisor.

Okay, but what does that mean? Simply put, the adjusted market capitalization is the total of every stock price multiplied by the number of shares of that stock.

For example, as of October 12, 2018, AAPL had the largest market cap in the world. The share price closed that day at a value of $222.11, with 4.83 billion outstanding shares. By multiplying the share price and the outstanding shares together, we get a market cap value of $1.073 trillion.

If you multiply both of these together for every stock in the S&P 500 then add them up, you’ll get the adjusted market capitalization of the S&P 500.

The divisor value is proprietary, meaning the company doesn’t release how they calculate it. However, if you know the index value and the adjusted market cap value, you can easily rearrange the equation to calculate the divisor value. Doing this shows the current divisor value is around 8.9 billion.

They change the divisor occasionally to prevent events like new stock releases and company spin-offs from impacting the true value of the index.

Below, you’ll find the basic equation for calculating the index value.

\frac{\sum_{i=1}^{n} (P_{i}\times Q_{i})}{\mathrm{Divisor}}

In this equation, P is the share price of stock i, Q is the market cap of stock i, and n is the number of stocks in the S&P 500 index.

Are you wondering why I didn’t just use 500 in place of n? Well, that’s because there aren’t always 500 stocks in the S&P 500. Remember, the S&P 500 contains 500 companies, but some companies distribute more than one stock. For example, Alphabet Inc. has both GOOG and GOOGL tickers in the S&P 500.

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Can You Invest in the S&P 500?

Once upon a time, investing in the entire S&P 500 was difficult. Unless you had a lot of money and an ambitious financial manager, it was borderline impossible. Why? Because 500+ constantly changing stocks are difficult to keep track of, even if you have enough money to buy them all.

With the advent of mutual funds and ETFs, investing in the entire S&P 500 became much more realistic. But, why would you want to invest in the entire S&P 500? Two reasons: quality and diversity.

By looking at the factors considered when choosing a stock for the S&P 500, we know the committee focuses on quality companies. While no company is perfect, this kind of quality can help protect you during nasty economic downturns. Sure, these companies will probably suffer too, but they’re more likely to survive.

In addition to the quality, the sheer quantity of stocks in the S&P 500 gives your portfolio some excellent diversity. As we know from above, the companies listed in the S&P 500 change over time. Not all companies last forever, and even the best can eventually fail. When you invest in 500 quality companies, diversification protects you if one of them suddenly drops like a rock.

Since the S&P 500 represents some of the top companies from every major sector of the U.S. economy, your portfolio will move with the economy. When the economy does great, so will your portfolio. When it suffers, your portfolio might suffer too. But, the U.S. economy has a history of long-term growth, making this a good long-term strategy.

My favorite ETF for investing in the S&P 500 is Vanguard’s VOO. Its price tracks the S&P 500, and it has a crazy low expense ratio of 0.04%. You can buy VOO like any other stock. But, when you buy it, it’s like you’re really buying a tiny piece of every stock in the S&P 500. How’s that for cool?

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TL;DR

The Standard & Poor Corporation was founded in 1941 when Poor’s publishing company merged with Blake’s Standard Statistics Bureau company. The S&P index started using 500 companies in 1957. The stocks in the S&P 500 are chosen by a committee based on a number of factors including market capitalization, liquidity, and financial viability, just to name a few. The S&P 500 index value is calculated by dividing the total adjusted market capitalization value of every stock in the index by a proprietary divisor value. Today, investing in the entire S&P 500 is relatively simple through both mutual funds and ETFs. Investing in the entire S&P 500 allows one to invest in both quality stocks while also diversifying a portfolio with all 500 companies.

What do you think about the S&P 500? Do you invest in it? Do you think it’s a good indicator of the U.S. economy? Let me know your thoughts in the comments below!

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