How to Invest in the S&P 500

The S&P 500 is an index comprised of 500 leading U.S. companies, and it powers some popular index funds.
Apr 15, 2022
How to Invest in the S&P 500

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For those would-be investors wanting to jump into the stock market but wondering which stock to buy, legendary investor Warren Buffett has a suggestion: Try buying 500 stocks instead.

“In my view, for most people, the best thing to do is own the S&P 500 index fund,” Buffett said at Berkshire Hathaway’s annual 2021 meeting. But what is the S&P 500, and how do you invest in one of its funds?

Here's an intro to how S&P 500 funds work, and whether one might be a good fit for your portfolio.

What is the S&P 500?

The S&P 500 is a stock market index comprising shares of 500 large, industry-leading U.S. companies. It is widely followed and often considered a proxy for the overall health of the U.S. stock market. Investing in an S&P 500 fund can instantly diversify an investor's portfolio.

Standard & Poor’s, an American investment information service, created the index in 1957. Every quarter, its investment committee meets to review which stocks belong in the index based on each company’s market size, liquidity and group representation. Today, over 500 stocks constitute the index, since some of the 500 companies have more than one class of shares.

Contrary to popular belief, the stocks forming the index are not the 500 biggest U.S. companies, but they are arguably some of the 500 most important companies: These stocks represent about 80% of the total U.S. stock market’s value.

A cap-weighted index, the S&P 500 weights the stocks within by market capitalization or total market value (number of outstanding shares multiplied by current market price). The larger the company, the greater its influence on the index.

What companies are included in the S&P 500?

As of April 14, 2022, these are the top 10 companies by index weight in the S&P 500:

  • Apple.

  • Microsoft.

  • Amazon.

  • Tesla, Inc.

  • Alphabet Inc. (Class A).

  • Alphabet Inc. (Class C).

  • NVIDIA Corp.

  • Berkshire Hathaway (Class B).

  • Meta Platforms Inc. (Class A).

  • UnitedHealth Group Inc.

How do you invest in the S&P 500?

An index is a measure of its underlying stocks’ performance, so you cannot directly invest in the index itself. Buying every company’s shares would be an arduous task (think hundreds of separate transactions), but thankfully there are index funds and exchange-traded funds, or ETFs, that replicate the index, effectively doing that work for you.

While all S&P 500 funds track the holdings of this index, an investor must consider whether using an index fund (a passively managed mutual fund) or an ETF makes the most sense for them. The good news when weighing index funds versus ETFs is that there are solid S&P 500 options in each category, and all of these products leverage the diversity of the index itself.

Because the S&P 500 is weighted by each company's market capitalization, the larger companies in the index can sometimes have an outsize impact on the performance of the larger index. In other words, a big dip in price for Apple shares can create a dip in the index as a whole. Because of this, some investors prefer to purchase the S&P 500 in an equal-weighted format, so that each company has the same impact on the index. This is meant to create an index that is more representative of the overall U.S. market.

After deciding your preference for an index fund or ETF, cap-weighted or equal-weighted, you can begin narrowing down which S&P 500 fund to purchase.

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Should you invest in the S&P 500?

There are a number of things to think about before you choose any investment, but an S&P fund can generally be a good choice if you want to add broad exposure to the U.S. stock market to your portfolio. Here are some things to consider:

Minimum investment

When you start investing in a fund, there may be a minimum amount of money you need to invest to get started. Fidelity's 500 Index Fund (FXAIX) has a $0 minimum investment; Vanguard's 500 Index Fund (VFIAX) requires a $3,000 minimum to get started.

Expense ratio

An expense ratio is an annual fee expressed as a percentage of your investment. If you invest in a mutual fund with a 1% expense ratio, you’ll pay the fund $10 per year for every $1,000 invested. That money is automatically taken out of your investment in the fund, meaning you won’t get a bill for the charge. Index funds and ETFs typically have lower expense ratios than actively managed mutual funds, but it's still worth examining a fund's expense ratio to see how much you'll be charged.

What do financial advisors think of the S&P 500?

“The S&P 500 is a key part of a diversified investing strategy because it’s a good bet that the U.S. economy will continue to succeed and grow in the long term,” says Tony Molina, a product evangelist at Wealthfront. "The U.S. has the largest economy and stock market in the world, and is one of the most resilient and active, especially when it comes to innovation. That’s why it’s a no-brainer to include the S&P 500 as part of your portfolio.”

Larger companies are generally more stable to invest in because they are well-established and widely followed. Thus, these stocks usually have less risk and lower volatility. The S&P 500 combines large companies across various industries, so investors access a broad, diversified mix of companies when investing in it.

Choosing an index fund or ETF can also help investors avoid — or at least minimize — the behavioral pitfalls from stock-picking, which is a losing strategy, says Dejan Ilijevski, an investment advisor at SCM Investment Services.

Ilijevski cites a study by professor Hendrik Bessembinder at Arizona State University, which examined investments in publicly traded U.S. stocks between 1926 and 2016 and found that just over 4% of the companies accounted for the total wealth created.

“Picking those few individual winners is impossible,” Ilijevski says. "Your best bet is to own as much of the market with a fund that tracks the index.”

Using index funds and ETFs can help investors generate strong returns while also minimizing their costs, says Kevin Koehler, chartered financial analyst and director of the investment strategy group at Miracle Mile Advisors in Los Angeles.

“Investing in the S&P 500 the past 25 years would have given an investor over a 10% annualized return, proving that an investor does not need to be paying high expenses to get good market returns,” Koehler says.

Are there drawbacks to investing in the S&P 500?

While an S&P 500 ETF or index fund may be a worthwhile investment, there are caveats to consider.

Overall diversification

The S&P 500 consists of only large-cap U.S. stocks. Portfolio diversification encompasses buying mid- and small-cap companies along with large-caps; allocating funds to international companies along with domestic ones; and including bonds, cash and potentially other asset classes with stocks.

Koehler also notes drawbacks in the S&P 500 related to its market-cap weighting.

“As passive investing increases, investors are continually investing in S&P 500 funds, which has contributed to a ‘rich get richer’ problem, where the largest stocks are getting larger due to S&P 500 investing, rather than individual stock investing,” Koehler says. “This can lead to higher volatility, as active managers sell an individual stock on top of index funds selling a portion. The market could continuously be overvalued compared to its underlying value.”

But relative to the downsides of many investment types, the flaws of S&P 500 funds seem relatively minor, especially when used as a part of your overall portfolio and held for the longer term. This helps explain why icons like Buffett have so publicly endorsed them.

"I happen to believe that Berkshire is about as solid as any single investment can be, in terms of earning reasonable returns over time," said Buffett at the May meeting, speaking about the investing company he's turned into an empire. "But, I would not want to bet my life on whether we beat the S&P 500 over the next 10 years."

Disclosure: The author held no positions in the aforementioned investments at the original time of publication.

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