Warren Buffet, one of the greatest investors of all times, famously said investing in low-cost index funds, and especially ones following the Standard & Poor 500 index (S&P 500) is best for most people.
If you want to follow that advice, remember the well-known admonition (often erroneously attributed to Mark Twain):
“It Ain’t What You Don’t Know That Gets You into Trouble. It’s What You Know for Sure That Just Ain’t So!” – Anonymous
With that in mind, here are 9 things you may think you know about the S&P 500 index that just “ain’t so.”
1. Does the S&P 500 represent the US stock market?
Yes and no.
According to S&P Global, “the S&P 500 is widely regarded as the best single gauge of large-cap U.S. equities,” and according to Morningstar, the index covers roughly 75% of publicly traded US stocks by capitalization.
However, it comprises just 500 of the largest US companies out of about 17,500 US companies, of which about 6000 trade on stock exchanges.
In this sense, no, the S&P 500 doesn’t fully represent the US stock market.
2. Does the S&P 500 comprise the 500 largest US companies?
No, it doesn’t.
It comprises 500 of the largest, but there are certainly companies excluded from the index that are larger than many S&P 500 constituent companies. This is because S&P 500 companies are selected by a committee using 8 criteria for each prospective stock:
- It must be common stock of a corporation trading on the NYSE, NASDAQ, or Cboe; with the plurality of its assets and revenues in the US.
- The company must not have more than one class of common stock (some current components with more than one class, like Google, are grandfathered).
- The market cap of the company must be at least $14.6 billion, and the float-adjusted market capitalization (i.e., the total value of publicly traded shares) must be at least half that.
- At least 10% of the common stock must be publicly traded.
- In the year prior to joining the index, the total value of shares traded must exceed the float-adjusted market capitalization.
- At least a quarter million shares must be traded in each of the 6 months prior to joining the index.
- Earnings for both the most recent quarter and the sum of the last 4 quarters must be positive.
- The shares must publicly trade for a year (on one of the above-mentioned indexes).
If a company doesn’t meet these criteria, it’s very unlikely to make it into the index, no matter how big it is.
3. Are there exactly 500 component stocks in the S&P 500?
There are in fact 505 stocks of 500 companies, because 5 companies (e.g., Google) have two classes of common stocks included in the index.
4. Does each component stock in the S&P 500 affect the index equally?
No, with a generous helping of heck no!
According to Slickcharts, the current weight of Apple (AAPL), with a market cap of $2.6 trillion (yes, with a “T”), is about 6.9% of the index; while the weight of Embecta Corporation (EMBC) is a mere 0.000005%.
This means that if AAPL went down 10% and EMBC increased 100-fold (assuming the price of all other S&P 500 constituents stayed constant), the 0.69% drop in the index due to AAPL’s drop would hardly be affected by even such a fantastical increase in EMBC’s price.
5. Do S&P 500 companies stay in the index forever?
The index was first introduced in 1957 (though earlier versions have been around since the 1920s), and according to Inc.com, in 1965 companies lasted an average of 33 years in the index, dropping to 20 years by 1990, and forecast to drop to 14 years by 2026.
6. Is the S&P 500 diversified?
Yes, but not as much as you may think.
The index does comprise shares of 500 companies, but because the index is market-cap weighted, the top 10 companies (11 stocks since Google has two share classes in the top 10) account for nearly 29% of the index.
Worse, 7 of these 10 companies, accounting for over 22% of the index, are in a single sector — technology.
This means that if tech tumbles, the S&P 500 takes an outsized hit.
7. Is it better to invest in funds following the S&P 500 rather than other indexes?
That’s a hard one.
The answer is, “It depends.”
The most famous US stock index is the Dow Jones Industrial Average, a price-weighted index of 30 stocks first created in 1896. The younger S&P 500 is far more diversified than the DJIA — it has almost 17x more component stocks.
Also, while the market-cap-weighted S&P 500 is affected far more by larger companies than by smaller ones, the DJIA is moved more by changes in more expensive stocks than cheaper ones.
This means it’s moved, e.g., more by changes in the price of Goldman Sachs (GS) than by similar moves in the price of Microsoft (MSFT), despite the fact that Microsoft’s market cap is over 19x larger.
On the other hand, as mentioned above, the S&P 500 only reflects about 75% of the total of publicly traded US stocks by capitalization, and excludes (by design) all small-cap stocks. Since the latter have out-performed large-cap stocks over the long term, that’s not so great.
For example, the 20-year annualized performance of the Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX), at 33.2%, is higher then that of the Vanguard 500 Index Fund (VFIAX), at 32.7%, leading to nearly 9% higher total return over that period as of this writing.
Another index that’s more diversified than the S&P 500 by market capitalization is the Nasdaq Composite Index, which helps if you want exposure to small-cap stocks in addition to large-cap.
However, while the S&P 500 includes shares of companies listed on multiple exchanges, the Nasdaq Composite Index, by definition, comprises only Nasdaq-listed stocks, which makes it even more tech-heavy.
If you prefer an index fund that moves by the same amount when any of its constituent stocks’ prices moves by a given percentage, there are funds that track the so-called S&P 500 Equal-Weight Index. There, each of the 500 companies’ stocks has the same 0.2% weight.
That may or may not be a good idea, depending on how mammoth companies perform relative to ones barely above the mid-cap cutoff.
8. Can I invest all my stock-allocated money in a fund following the S&P 500?
You can, but as I like to say, just because you can do something that doesn’t mean you should do it.
As mentioned above, this index excludes the 25% smallest-cap US companies, and over the long haul those have out-performed large-cap stocks.
It also excludes international stocks, that can reduce volatility without sacrificing performance.
According to Hulbert Ratings, a portfolio with 80% S&P 500 and 20% in the MSCI’s Europe, Australasia and Far East (EAFE) index returned the same ~12% annualized return from 1970 to 2021 as a 100% S&P 500 portfolio, but with about 9% less volatility.
Further, given the nearly identical long-term returns of the two indexes, the far-higher recent return of the S&P 500 (nearly triple that of the EAFE over the past decade) implies that continued S&P 500 over-performance is less likely than under-performance in the coming years.
9. Are all S&P 500 companies’ profits from the US?
Yes, all companies in the index are US companies.
However, many have global reach. In fact, in 2014 nearly 48% of S&P 500 component companies’ sales were from foreign countries. In 2003, that number was at a low of “just” 42%. More recently, in 2018 it was about 43%.
Thus, while the index doesn’t provide exposure to international stocks, it does provide exposure to international economies.
The Bottom Line
The S&P 500 is a very well-known index of large-cap US stocks, covering about 75% of all publicly traded US stocks by market cap. It comprises 505 stocks of 500 companies selected by a committee using 8 criteria.
While the index is diversified, investing only in an S&P 500 index fund will give you no exposure to the historically better-performing small-cap stock sector.
Such a strategy would also give you no exposure to international stocks that could reduce your portfolio’s volatility without losing long-term performance, and may actually out-perform in the coming years if we experience “reversion to the mean” (however, between 42% and 48% of sales of S&P 500 component companies came from overseas, so you will gain exposure to international economies).
If you choose to follow Buffet’s advice to invest in low-cost index funds, you can find many ETFs and mutual funds that follow the S&P 500. Your money would then join over $5.4 trillion invested in funds tracking the index, and would likely outperform 80% of actively managed mutual funds.
This article is intended for informational purposes only, and should not be considered financial, investment, business, tax, or legal advice. You should consult a relevant professional before making any major decisions.