How Does Standard & Poor’s 500 Index Work?
The Standard & Poor’s 500 (S&P 500) tracks the 500 largest (measured by market value) publicly traded companies. The publishing firm Standard & Poor’s created this index.
Because it contains 500 companies, the S&P 500 represents overall market performance better than the Dow Jones Industrial Average’s (DJIA) 30 companies. Money managers and financial advisors actually watch the S&P 500 stock index more closely than the DJIA.
Most mutual funds especially like to measure their performance against the S&P 500 rather than against any other index. Mutual funds that concentrate on small-cap stocks usually prefer an index that has more small-cap stocks in it, such as the Russell 2000.
The S&P 500 doesn’t attempt to cover the 500 “biggest” companies. Instead, it includes companies that are widely held and widely followed. The companies are also leaders in a variety of industries, including energy, technology, healthcare, and finance. The index is market-value weighted.
Although it’s a reliable indicator of the market’s overall status, the S&P 500 also has some limitations. Despite the fact that it tracks 500 companies, the top 50 companies encompass 50 percent of the index’s market value. This situation can be a drawback because those 50 companies have a greater influence on the S&P 500 index’s price movement than any other segment of companies.
In other words, 10 percent of the companies have an equal impact to 90 percent of the companies on the same index. Therefore, although the index better represents the market than the DJIA, the index may not offer an accurate representation of the general market.
S&P doesn’t set the 500 companies they track in stone. S&P can add or remove companies when market conditions change. They can remove a company if it isn’t doing well or goes bankrupt, and they can replace a company in the index with another company that is doing better.