One of the most popular methods for investing in the stock market is through the S&P 500 Index. Investment advisors frequently recommend it as the primary choice for the stock portion of a typical investor’s portfolio.
But how does the S&P 500 work, and what’s the best way to buy the index?
To help you incorporate the S&P 500 into your portfolio, we’re providing this S&P 500 investing guide. But before we describe how, let’s first dive into exactly what the S&P 500 is so you’ll have a better idea of why it’s such a well-recommended investment.
Table of Contents
- What Is the S&P 500?
- What Companies are Included in the S&P 500?
- The S&P 500 vs. Dow Jones Industrial Average and NASDAQ
- How to Invest In the S&P 500
- Pros and Cons of Investing in the S&P 500
- Should You Invest in the S&P 500?
What Is the S&P 500?
The S&P 500 Index tracks the performance of the 500 largest publicly traded corporations in the United States. However, the actual number can fluctuate, higher or lower, at any given time (the total number of companies held in the index is currently 503). Before you invest, it’s important to understand that it does not include non-US companies or small capitalization companies.
Though the index was officially launched on March 4, 1957, it has been valued going back to January 3, 1928, covering many decades before the index even began.
Because the S&P 500 represents the largest companies, it’s often regarded as the go-to representation of the overall US market. This connection is not without merit, given that it comprises companies with a total market value of about $13.5 trillion. That represents roughly 2/3 of the total market value of the stock of all publicly traded companies on US markets.
The S&P 500 Index uses a float-adjusted market weighing method. That is, the weight of each of the 500 companies in the index is based on each company’s market capitalization. Therefore, companies with the largest market capitalization will have a disproportionate impact on the index’s performance.
What Companies are Included in the S&P 500?
To be eligible for inclusion in the index, a company must meet the following criteria:
- Must have an unadjusted market capitalization of $14.6 billion and a float-adjusted market capitalization of at least 50% of the unadjusted minimum market capitalization threshold.
- Companies must have an investable weight factor (IWF) of at least 0.10% (public float).
- Must have positive as-reported earnings over the most recent quarter, as well as over the most recent four quarters (summed together).
- Must meet adequate liquidity and reasonable price.
- Meet sector representation requirements.
Companies can trade on the New York Stock Exchange, the NASDAQ, or even trade over-the-counter (OTC). Real estate investment trusts (REITs) can be included, but not closed-end funds, ETFs, American depositary receipts (ADRs), and certain other types of securities.
The ten largest companies by index weight are the following:
Because the S&P 500 index represents the 500 largest companies, it automatically includes exposure to primary market sectors. The current breakdown of the ten largest sectors is as follows:
- Information Technology, 27.3%
- Health Care, 14.1%
- Consumer Discretionary, 11.4%
- Financials, 10.9%
- Communication Services, 8.4%
- Industrials, 7.9%
- Consumer Staples, 6.8%
- Energy, 4.7%
- Utilities, 3.1%
- 10. Real Estate, 2.9%
The index isn’t fixed when it comes to either companies or sectors. For example, in the years after World War II, industrials likely represented the largest sector in the index, while today, that sector has been overtaken by information technology and healthcare. Many of the largest companies in the index today didn’t exist even 50 years ago.
The S&P 500 vs. Dow Jones Industrial Average and NASDAQ
As popular as the S&P 500 index is, it’s one of many benchmark indexes investors can use for their stock allocations. The two leading competitors are the S&P 500, the Dow Jones Industrial Average, and the NASDAQ.
(The broadest index of the entire US stock market is the Wilshire 5000 Index, which tracks the performance of all 3,600+ publicly traded companies in the US.)
Dow Jones industrial average (DJIA)
There was a time, not so many years ago when the Dow Jones Industrial Average was the favorite barometer of the performance of the stock market. Similar to the S&P 500, the DJIA also represents the largest publicly traded companies in America, particularly the ones that are household names.
But while the Dow Jones Industrial Average continues to be widely tracked and quoted, it’s no longer the industry standard.
That’s large because the Dow Jones includes just 30 companies, compared to 500+ for the S&P 500. The S&P 500 simply represents a broader cross-section of the largest companies,
Even though it’s the Dow Jones Industrial Average, industrial companies make up only 13.8% of the index. Health care, information technology, and financials are bigger sectors.
The S&P 500 has also turned in a better performance than the Dow Jones over the long run. While the S&P 500 has returned an average of 11.09% per year over the past decade, the Dow Jones has averaged just 8.67%. That’s likely because the larger number of stocks in the S&P 500 includes a large number of up-and-coming companies whose stocks are outperforming the 30 companies in the Dow.
Though the NASDAQ is an index (the NASDAQ Composite), it is also a stock exchange. But there are different variations of the NASDAQ as an index, some taking in the entire market and others centering on a specific sector within the market. The exchange is based in New York and has nearly $20 trillion total market capitalization. That makes it the second largest stock exchange in the world, after the New York Stock Exchange.
NASDAQ bills itself as the first electronic stock market listing with over 5,000 companies, though it currently has only a little over 3,500. It comprises two separate markets, the NASDAQ National Market and the NASDAQ Small Cap Market. Because it does comprise so many publicly traded companies, it’s broader as an index than either the Dow Jones or the S&P 500.
As an index, the NASDAQ Composite represents the full NASDAQ market. But there are sector indexes comprised of more limited numbers of NASDAQ stocks. An example is the NASDAQ 100. It represents 100 or so NASDAQ listed non-financial companies with the largest market capitalizations. This includes many popular tech companies like Apple, Amazon, Microsoft, and Tesla.
As represented by the Invesco QQQ Trust (QQQ), the fund has produced an average annual return of just over 17% over the past decade.
How to Invest In the S&P 500
In today’s world of online investing, how to invest in the S&P 500 is much easier than you may think.
Open a Brokerage Account
This is where the process starts because once you open a brokerage account, you’ll be free to invest in the S&P 500 or any other index.
Examples of brokers include Ally Invest, E*TRADE, and M1 Finance.
Ally Invest offers both self-directed investing and managed investment options. With self-directed investing, you can trade stocks, options, and exchange-traded funds (ETFs) commission-free. What’s more, Ally Invest is currently offering a sign-up bonus for new accounts for as much as $300.
E*TRADE works similarly to Ally Invest in that you can open a self-directed investment account where you can trade stocks, options, and ETFs commission-free. They also offer a bonus, paying between $50 and $3,500 when you open and fund a new account.
Still another example is M1 Finance, a popular robo-advisor that lets you invest in individual stocks and ETFs online and is fully automated. You can create several portfolios, referred to as “pies,” and fill each with as many as 100 stocks and funds. That can include one or more funds based on the S&P 500 index.
These are just three of the many investment brokerages available if you want to invest in the S&P 500.
Choose an Index Fund
Once you open a brokerage account, the next step will be to choose an index fund.
An index fund is an ETF or mutual fund (but much more commonly, an ETF) whose performance is tied directly to an underlying index – like the S&P 500.
Index funds operate differently from actively traded funds in that they only track the index they’re tied to. That means that while they’ll match the index, they won’t outperform or underperform it. And because it is an index, they rarely trade. That keeps expense ratios very low, generally below 0.20% per year.
If an index fund is an ETF, you can generally buy and sell shares commission-free. You can typically buy into an ETF for the cost of a single share, though some investment platforms – like M1 Finance – will allow you to buy fractional shares, which is a slice of a full share.
Actively traded funds are typically mutual funds. Since they are not based on an index, the fund manager attempts to outperform the general market. This often results in a lot of trading, which raises expense ratios.
And since they are generally mutual funds, they may have high minimum investments, like $3,000. Many mutual funds also charge load fees. These are sales commissions equal to between 1% and 3% of the value of the fund traded.
By contrast, index-based ETFs don’t charge load fees and will be your best choice if you want to invest in the S&P 500.
Examples of popular ETFs tied to the performance of the S&P 500 include:
Vanguard S&P 500 ETF (VOO)
iShares Core S&P 500 (IVV)
SPDR S&P 500 ETF (SPY)
Any of these funds will be a solid choice if you want to invest in the S&P 500.
Have a Long-Term Mindset
As mentioned earlier, index funds – like the S&P 500 – are designed to match the performance of the underlying index. That means they match the market but neither outperform nor underperform it (yes, I’m repeating that point, but only because it’s important!).
That’s why it’s important to think long-term when you invest in the S&P 500. As an index fund, it’s unlikely to double or triple over the next year or two. More likely, you’ll experience annual gains in a 10%-plus range, as well as losses at a similar rate.
But the key to index investing is to buy and hold over the long term. The market can rise and fall in any single year, so it’s the performance of that market over several years that provides long-term gains. That’s why the S&P 500 has provided an average return of over 11% per year for the past decade.
Pros and Cons of Investing in the S&P 500
- The S&P 500 represents the most widely recognized investment index in the world.
- Provides exposure to the 500 largest companies in America
- This index has provided double-digit gains for the past decade, despite occasional dips.
- It avoids the need to choose and manage a portfolio of individual stocks.
- Since it can be purchased through an index fund, no need to pay commissions, and MERs are extremely low.
- It makes an excellent core holding for your stock portfolio
- The S&P 500 Index tracks only US-based companies, no small-cap.
- The index’s performance will largely be determined by the companies with the highest market capitalization.
- It’s possible to lose money in a fund based on the S&P 500.
Should You Invest in the S&P 500?
The decision to invest in any asset class or individual security is a highly subjective one. You should invest in the S&P 500 only if, after careful investigation, the fund fits within your own investment needs and preferences.
That said, the S&P 500 is commonly recommended as a portfolio holding by investment advisors. It’s also a frequent position in professionally managed portfolios, including those of robo-advisors.
Though it isn’t completely safe (few investment vehicles are), it does have a history of consistent returns, including over 11% annually for the past ten years.
An investment in the S&P 500 is best held as a long-term, core holding in your stock portfolio. That’s because it represents the upper end of US stock markets and is generally less volatile and more consistent than individual securities.
If you’re unsure if the S&P 500 is right for you, consult with a licensed investment advisor to help you make your decision.