Why Is The S&P 500 Index Important in Investing?

Why Is The S&P 500 Index Important in Investing?

Reading time: 6 minutes

One of the most fundamental indices investors learn about when they start in the market is the S&P 500 index. You can think of the S&P 500 Index as a barometer or benchmark for the US stock market, as the index includes 500 large blue-chip companies.

Most of these shares are traded in the New York Stock Exchange (NYSE) or Nasdaq, two of the most dominant global stock markets.

Today we’ll explore why many global and American investors use the S&P 500 to measure the US equity market and how it weighs against similar indexes.

S&P 500 Index in a Nutshell

The Standard & Poor’s 500, or S&P 500 in short, is a stock market index comprising 500 large-cap and publicly-traded companies in the US. The index is a benchmark for the US stock market and serves as a barometer for the US economy.

Various exchange-traded funds (ETFs) and mutual funds available to investors are linked to the S&P 500 index performance.

How Does the S&P 500 Index Work?

S&P 500 is a market-capitalisation-weighted index and includes companies among the largest in the world. Market cap is calculated by multiplying the stock price by the number of outstanding shares.

Source (Trading View)

The market-cap weighting instead of price-weighted indexing implies that stock price volatility of the largest companies (based on market cap) like Apple Inc (AAPL), Alphabet Inc (GOOGL), Microsoft Corp (MSFT), Amazon.com, Inc (AMZN), or Tesla Inc (TSLA) can significantly impact the S&P 500 due to their large market caps.

S&P Dow Jones Indices oversee the value of the S&P 500 index. Here’s how the calculation takes place. First, they find each company’s adjusted market cap and add it before dividing it with a proprietary divisor. Several factors that play a role in the divisor’s value include stock splits, special dividends, spinoffs, and more. Regular adjustments ensure the continuity and applicability of the index over time. 

Key Benefits of Investing in S&P 500 ETF

Investing in an S&P 500 ETF comes with many benefits to both experienced and beginner investors. The key advantages include:

• Broad exposure and diversification: The S&P 500 exposes an investor to companies from all eleven sectors of the US economy. You will find prominent names from information technology, healthcare, real estate, consumer discretionary, manufacturing, etc. It means you won’t have to bet on a sector-specific success and can benefit from the country’s overall economic growth.
• Low management cost: You can benefit from the lower expense ratio and management fee of S&P 500 ETFs compared to the actively managed ones.
• High liquidity: With relative ease, you can buy or sell the S&P 500 ETFs at the market price on any regular trading day, like individual stocks on major exchanges.
• Solid AAR performance of the S&P: Historical data of past performance suggests that the S&P 500 has delivered a solid average annual return (AAR) of 10.15% from 1957 through the end of 2022. AAR is a good measure of success for any ETF or mutual fund.
• Passive income: Many S&P 500 ETFs disburse regular dividend payments out of positive earnings facilitating a passive income source for you.

Risk Factors to be Aware of When Investing in S&P 500

Though offering multiple benefits, investing in the S&P 500 index has several risks. Let’s take a quick look at some of the dominant risk factors you should consider:

• Despite the diversified allocation of companies, S&P 500 concentrates on market cap, meaning it fluctuates heavily due to price changes in larger entities.
• Political stability, geopolitics, interest rates, and trade disputes often play a significant role in the index's performance.

Alternative Investment Options Similar to the S&P 500 Index Fund

While the S&P 500 is generally a popular investment choice, it’s certainly not the only option. For instance, the Dow Jones Industrial Average is another old and widely followed index that tracks 30 large companies listed in the US. However, if you want to focus more on the technology sector, the Nasdaq Composite enables you to do so while it is less diversified.

FP Markets, a global Forex and CFDs brokerage, facilitates access across various asset classes and ETFs, including Forex, commodities, bonds, stocks and global indices (including the S&P 500 and Nasdaq 100). Visit FP Markets today and consider opening a demo account with one of FP Markets’ leading Trading Platforms.