What Is an Index and How to Invest in One

For investors, an index tracks the performance of a group of assets. The S&P 500 is a well-known stock market index.
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Written by Kevin Voigt
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What is an index?

An index tracks the performance of a group of preselected investments, such as stocks. For example, the S&P 500 index tracks the performance of 500 of the largest U.S. companies. Investors gauge the performance of stocks, bonds or mutual funds by comparing them with the performance of an index.

The S&P 500 and the Dow Jones Industrial Average are two of the most well-known stock market indexes. While these indexes track the broad market and large-company stock movements, other indexes may track only a certain industry or market sector.

» Learn more: What is the S&P 500?

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You've probably heard about the S&P 500, so today we're going to talk about it. And whether you're new to investing or you've been doing it for a while, having a fundamental understanding of the S&P 500 can really help your investing journey.

Today, we're going to talk about the S&P 500, what it is and how to invest in it. One quick note: I am not a financial advisor, and this is not personalized investment advice.

The S&P 500 stands for Standard & Poor’s 500, which is really just a measure of how the U.S. economy is doing. It's a collection of 500 of the largest U.S companies, and people look at this as a way of seeing how the economy is doing as a whole. Now, this measurement has been around for a long time — it's 65 years old, and it's a really great place to start your investing journey. It's a good first investment, and it's also a good second or third investment.

So you can't actually invest in the S&P 500 itself. The S&P 500 is a market index — it's a collection of these stocks as a way of just measuring the economy.

But you can't just go out and buy an S&P 500 stock. You can, however, invest in things that track the index, and so they'll have really similar performance.

For nearly the last century, the average annual total return of the S&P 500, which includes dividends, has been about 10%, not adjusting for inflation. But this doesn't mean that you can expect to get a 10% return on your investment in the S&P 500 every single year.

In 2008, for example, the S&P 500 finished the year down a staggering 37%. The following year, it finished up 26%.

Earning a 10% average annual total return requires a long-term investing mindset and a willingness to ride out market volatility. Stepping back and looking at the S&P from a historical lens, the S&P soared into the early '80s after the inflation scene in the '70s, then crashed in the early 2000s during the financial crisis, often referred to as the Great Recession. There was pretty steady growth in the decade leading up to the pandemic when it fell again along with the rest of the economy.

With inflation settling in again, no one really knows what will happen next, so let's dig a little deeper into what it takes to become a part of the S&P. There's a couple of things that a company has to do in order to be considered to be part of the S&P 500. First, they have to have a market capitalization, which just refers to the total value of a company's outstanding shares, of at least $8.2 billion.

They have to be based in the U.S., and they have to be structured as a corporation and offer common stock. That's just stock that average people can buy. They also have to be listed on an eligible U.S. exchange and have positive as reported earnings over the most recent quarter in addition to over the four most recent quarters added together.

Thanks to this criteria, only the country's largest, most stable corporations can be included in the S&P 500. Market cap is calculated by multiplying the number of stock shares a company has outstanding by its current stock price. So if a company has 2 million shares currently held by shareholders and the current share price is $5, then the company's market cap is $10 million. In simpler terms, the company has a value of $10 million.

The S&P 500's value is calculated based on the market cap of each company, adjusted to consider only the number of shares that are traded publicly. However, each company in the S&P 500 is given a specific weighting obtained by dividing the company's individual market cap by the S&P 500's total market cap. Thus, companies with larger market caps are weighted more heavily than those with smaller market caps.

To arrive at the number we're accustomed to seeing on the S&P 500 ticker, the index's total market cap is divided by a proprietary divisor. As the share prices of S&P 500 companies move throughout the day, each movement has an impact on the value of the index.

In order to invest in pretty much anything, you have to have what's called a brokerage account. This is an account where you can purchase investments from, but keep in mind that when you open one of these accounts, whether it's a standard brokerage account or a retirement-friendly account like a Roth IRA, just opening this account doesn't mean that you're invested in anything.

You have to fund it and then purchase investments from there. So once you have a brokerage account, you're able to put some money in, and then you can purchase investments, like an S&P 500 index fund or ETF or stocks that are representative of the ones that are in the S&P 500.

And while you can't buy S&P 500 stock, you can buy the same stocks that are represented within the S&P 500 itself. Here are the top 10 holdings or the companies that make up the biggest percentages. The top three are Apple, Microsoft and Amazon. You can purchase these stocks to mimic the S&P 500, but doing so is more complicated and comes with more risk than purchasing a fund.

Index funds and ETFs are baskets of stocks that offer other securities that you can invest in all at once. These funds will track the entirety of the S&P 500, and they'll likely perform similar to how the index itself performs. And rather than buying individual stocks to mimic the S&P 500, you can invest in a fund that just does the entire thing for you all in one investment.

Now, both index funds and ETFs tend to be fairly inexpensive, and they offer a lot more diversification by holding lots of companies rather than just a few, so you could purchase an index fund that has about 500 of the stocks in the S&P 500 or you could buy the top three stocks represented as singular stocks. You can see how the diversification becomes a real benefit when working with funds. Now, the biggest difference between ETFs and index funds is how they're traded, but they have a few other smaller differences as well. But this really shouldn't matter to long-term investors, but if you're really curious, we do have a video on the difference between index funds and ETFs that you can check out.

With a little bit of practice, a single glance at the S&P 500 can tell you a lot about the health of the U.S. economy, and if you're using an index fund or an ETF to invest in the S&P 500 and track it, that means that a single glance at this market index can tell you a lot about how your money is doing.

And what's great about the S&P 500 is that it has a long history, so even in the dips and the highs of the market, typically the S&P 500 trends upwards over time, and that's what makes it a really helpful tool for helping you to invest for the future.

I'm Alana Benson, an investing writer for NerdWallet. If you're looking for S&P 500 ETFs, we have a list on NerdWallet that can help you narrow down your search, and if this video was helpful, please like and subscribe.

Index investing: Index funds and ETFs

Individual stocks and actively managed mutual funds attempt to “beat” the market — that is, perform better than their benchmark indexes. But these attempts often fail, and more investors are using passive investing strategies: index funds or exchange-traded funds that aim to mirror broad-market or sector performance rather than beat it.

» Ready to start investing? Understand how to invest with index funds

Index funds and ETFs are funds that hold stocks that are representative of an entire index, such as the S&P 500, so that the performance rises and falls alongside that benchmark index. As index values tend to rise over time, index funds and ETFs have become an important way that investors build long-term wealth.

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Stock index examples

Here are some common indexes that investors — as well as a range of index funds and ETFs — follow:

1. S&P 500 Index: The S&P 500 tracks the market moves of around 500 of the largest publicly traded companies in the U.S. The index is a representation of leading companies in leading industries and is capitalization-weighted, which means each stock is weighted proportionately to the company’s market capitalization. For example, a company whose total shares are valued at $100 billion is weighted more heavily than a $10 billion company. Learn how to invest in the S&P 500.

2. Dow Jones Industrial Average: The DJIA follows the performance of the 30 largest U.S. companies, also known as “blue chip” stocks. Market capitalization is not considered in this index.

3. Bloomberg Barclays U.S. Aggregate Bond Index: Also known as the Agg, this is a broad index that tracks the U.S. bond market. The index measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market.

4. Nasdaq Composite Index: The Nasdaq tracks the performance of more than 3,000 technology-related companies.

5. Russell 2000 Index: This index tracks 2,000 smaller — also known as small-cap — companies with market capitalization between $300 million and $2 billion.

» Explore further: What are the best index funds?

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