Stock Market Bubble? Here's How to End Up a Winner
If you're afraid of a pop, it's best to be prepared.
When it comes to the major U.S. stock indexes, none is more highly regarded as a barometer of the overall stock market’s performance and an indicator of how large corporations are performing than the S&P 500 index.
With that in mind, here’s what all investors should know about what the S&P 500 index is, how it works, how you can invest in it, and why doing so could be a smart move for you.
The S&P 500 (also known as the Standard & Poor's 500), a registered trademark of S&P Dow Jones Indices, is a stock index that consists of the stocks of 500 of the largest companies in the United States stock markets. It is generally considered the best indicator of how U.S. stocks in general are performing.
The S&P 500 index is weighted by market capitalization, which means that larger companies make up a greater portion of the index’s value and therefore have more influence over its performance. In other words, each company doesn’t simply represent 1/500 of the index. Massive companies like Apple (NASDAQ:AAPL) and Amazon (NASDAQ:AMZN) have a greater impact on the S&P 500 index than relatively smaller companies like Macy’s (NYSE:M) and Harley-Davidson (NYSE:HOG).
One key point to know is that although these are 500 large companies, there’s a wide range. Several of the largest companies in the index have market caps in excess of $1 trillion, and they are more than 200 times larger than the smallest S&P 500 components, which have market caps between $6 billion and $7 billion.
The value of the S&P 500 index fluctuates continuously throughout the trading day, based on the weighted performance market data of its underlying components.
The S&P 500 index is composed of 505 stocks issued by 500 different companies. There’s a difference in numbers here because a few S&P 500 component companies issue more than one class of stock -- for example, Alphabet Class C (NASDAQ:GOOG) and Alphabet Class A (NASDAQ:GOOGL) are both included in the S&P 500 index.
Obviously, it wouldn’t be practical to list all of the S&P 500 components here. However, because the S&P 500 is a market cap-weighted index, its performance is mostly dependent on the largest stocks it contains.
With that in mind, here’s a look at the 10 largest components of the S&P 500 index as of February 2020, although it's important to keep in mind that the order can (and probably will) change over time:
Data source: Dow Jones S&P Indices.
In short, the S&P 500 consists of a broad basket of stocks without too many small and obscure companies. It contains the companies widely owned by individual investors, with the 500 components accounting for roughly 80% of the overall stock market capitalization in the United States.
One common question is why the S&P 500 is considered by most experts to be a better stock market indicator than the Dow Jones Industrial Average. After all, the Dow's value is typically the headline number you see on TV.
However, the Dow has two big shortcomings. For one thing, it includes only 30 companies, and it leaves off some of the largest stocks in the market -- for example, top-10 S&P 500 stocks Amazon, Alphabet, and Berkshire Hathaway are all notably absent from the Dow.
Second, and most importantly, the Dow Jones Industrial Average is a price-weighted index. This means that companies with higher stock prices have more of an influence on the index than those with lower per-share prices, even if they are much smaller companies. As an example, Goldman Sachs (NYSE:GS), with a $238 share price currently, has more than twice as much weight in the Dow as Walmart (NYSE:WMT), despite being just one-fourth of the size by market cap.
In short, the S&P 500 covers far more stocks than the Dow, and it does so with a weighting that makes far more sense for trying to gauge the overall stock market's performance.
You can invest in the S&P 500 index by purchasing shares of a mutual fund or exchange-traded fund (ETF) designed to passively track the index. These are investment vehicles that own all the stocks in the S&P 500 index in proportional weights.
One good example is the S&P 500 funds offered by Vanguard. The Vanguard S&P 500 ETF (NYSEMKT:VOO), which trades just like a stock, and the Vanguard 500 Index Fund Admiral Shares (NASDAQMUTFUND:VFIAX) mutual fund both have extremely low fees and deliver virtually identical performance to the S&P 500 index over time.
In addition, S&P 500 futures contracts trade on the Chicago Mercantile Exchange, which allows investors to essentially buy or sell options contracts on the entire index.
Legendary stock market investor Warren Buffett has famously said that a low-cost S&P 500 index fund is the best investment that most people can make. And it’s not difficult to see why. Over long periods, the S&P 500 has delivered annualized total returns of 9%-10%, and you can invest in a passive S&P 500 fund for virtually no cost.
To be clear, if you have the time, knowledge, and desire to properly research stocks and maintain a portfolio, we (and Warren Buffett) feel that it’s certainly possible to achieve superior investment returns relative to the S&P 500 over the long term. However, not everyone has the time and discipline needed to invest in stocks that way, and newer investors in particular may be better off using an S&P 500 index fund to invest until they build up their knowledge.
In a nutshell, investing in the S&P 500 is a way to get broad exposure to the profitability of American businesses without too much dependence on any individual company’s performance. Over time, the S&P 500 can produce strong returns in your portfolio, and with minimal effort on your part.
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