The Dow Jones Industrial Average usually gets most of the attention, but the S&P 500 Index is much more important to the investment world. Index funds that track the S&P 500 hold hundreds of billions of dollars, and thousands of fund managers and other financial professionals track their performance against this ubiquitous index. But what exactly is the S&P 500, anyway?
The Standard & Poor's 500 as we know it today came into being on March 4, 1957. The makers of that first index retroactively figured its value going back to 1926, and they decided to use an arbitrary base value of 10 for the average value of the index during the years 1941 through 1943. This meant that in 1957 the index stood at about 45, which was also the average price of a share of stock. The companies in the original S&P 500 accounted for about 90% of the value of the U.S. stock market, but this percentage has shrunk to just more than 75% today as the number of stocks being traded has expanded.
Although it's usually referred to as a large-cap index, the S&P 500 does not just consist of the 500 largest companies in the U.S. The companies in the index are chosen by a committee at investment company Standard & Poor's. The committee meets monthly to discuss possible changes to the list and chooses companies on the basis of "market size, liquidity, and group representation." New members are added to the 500 only when others drop out because of mergers or (less commonly) a faltering business.
Some types of stocks are explicitly excluded from the index, including real estate stocks and companies that primarily hold stock in other companies. For example, Berkshire Hathaway (BRK.B), the holding company of Warren Buffett, arguably the world's greatest investor, isn't included, despite having one of the largest market values of all U.S. companies. Also, the index is composed exclusively of U.S. companies today.
Size matters with the S&P 500. Because the companies chosen for the index tend to be leaders in their industries, most are large firms. But the largest of the large-capitalization stocks have a much greater effect on the S&P 500 than the smaller companies do. That's because the index is market-cap-weighted, so that a company's influence on the index is proportional to its size. (Remember, a company's market cap is determined by multiplying the number of shares outstanding by the price for each share.) Thus, ExxonMobil (XOM) and General Electric (GE), with the two biggest market caps among U.S. companies, accounted for 4.2% and 2.4%, respectively, of the S&P 500 as of June 2008. In contrast, other smaller companies can account for less than 0.1% of the index.
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