Three things to remember about the S&P 500

The magical rise of the S&P 500 continues. The S&P 500 consists of the 500 largest US companies selected by a panel of investment analysts at Standard and Poors. It has turned into an easy moniker that represents the US economy.

I worked in index creation for a few years, and I want to remind you about some S&P 500 characteristics that people forget but might have adverse consequences in the future. Here are three important things I would keep in mind if you have S&P 500 shares in your portfolio:

1. The S&P 500 is cap-weighted and not equal-weighted, each of those 500 companies occupies not an equal share, but a share of the index based on their market cap.

For example, Apple is currently (Oct 2020) about 3% of the S&P 500 as the index is market cap weighted. If it were equal weighted Apple would only be 1/500th or 0.2% of the index. Apple is therefore 15 times as heavy in a cap-weighted index as in an equal-weighted index.

Now, if Apple shares go up because it’s market-cap-weighted; the space that Apple occupies in the S&P 500 will amplify, and in an environment like the current one where we have very high valuations — for companies such as Alphabet, Apple and Amazon — they take up an unprecedented amount of the S&P 500.

Think of the S&P 500 as a balloon with a dot representing Apple drawn on it. As Apple’s share price goes up the dot expands much faster than the other dots and the balloon looks like its inflating much faster than it is. That is fine if the balloon keeps expanding but worrying when the balloon starts to contract.

2. Secondly, the S&P 500 is balanced quarterly. Every three months the committee decides which of the companies are going to fall out of the index and which ones they allow in.

If you’re holding the S&P 500 and there is a company that you know is going to go downhill in the next three months because it has hit major difficulty, it’s position in the S&P 500 doesn’t change. The market is just going to keep holding that company, that’s why we see this resiliency with companies which you think ‘oh, it should be going down’, but it doesn’t go down as much as you think it would.

3. Thirdly there are more sophisticated versions of the vanilla S&P 500 such as the S&P 500 Quality Index which picks the highest quality 100 companies out of the 500 companies. As I write this (October 2020), the quality index has outperformed the plain S&P 500. I would encourage you to research versions of the S&P 500 that might suit your portfolio better.

Mallika Paulraj is the creator of The Superinvestar Framework which teaches investors how to make confident investment decisions. You can download your own copy of Ten Timeless Principles From The World’s Greatest Investors here. Her book How The Best Invest, which outlines the method, is available on Amazon.

Sign up to her weekly Four Minute Investing note via her website.

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Mallika Paulraj

Mallika Paulraj

Creator of The Superinvestar Framework | Author of How the Best Invest — Make Confident Decisions Like the Investing Superstars