Stock Indexing...
Previously, we talked about stock indexes as a list of companies, all of which meet some sort of criteria for inclusion on the list. Indexes include the Dow Jones Industrials average, which is often called the Dow, and Standard and Poor’s 500 index, or the S&P 500. With 30 of the world’s largest and highest profile companies, the Dow is often cited among media outlets. However, the Dow has a much more narrow range compared to the S&P 500’s broad base of around 500 companies from all sectors of the economy. In fact, the S&P 500 is typically used as a default term for the stock market. If someone mentions the stock market without specifying a certain index, they usually mean the S&P 500.

Wide Range
The number of companies stock indexes include can range from dozens to hundreds. As previously discussed, reducing single-stock risk through a broad-based diversified portfolio can be a good option for retirement investors as opposed to owning single company stocks, which are not only vulnerable to overall economic challenges, but company-specific risks as well. Because the S&P 500 index contains hundreds of stocks from every corner of the economy, it can be an effective index for building a broadly diversified portfolio.

Index Weighting
Stock indexes not only differ by how many or what kind of companies are included, but also by how each stock is weighted within the index. For indexes that are equal-weighted, each stock makes up the same portion of the fund. For example, if an equal-weighted fund had 10 stocks, each stock would make up 10% of the fund. In a price-weighted fund, the portion each stock represents is determined by the dollar amount of the share price, and stocks with higher dollar values make up a higher percentage than stocks with lower values. However, neither of these methods of weighting indexes takes into account the actual value of the company. Equal weighting ignores company values, and the dollar amount of one share of a company does not indicate that company's total value. A company with a lower share price could be more valuable than a company with a higher share price depending on how many shares exist.

Market Cap
Capitalization-weighting takes into account the value of each company based on the total number of shares multiplied by the current share price. Companies with a higher market capitalization, or cap for short, will have a higher portion of the fund than companies with a lower market cap. This is widely regarded as a more effective way of weighting indexes than other methods as it takes into account the overall value of each company. While the frequently cited Dow index is price-weighted, the S&P 500 is capitalization-weighted. In addition to its broadly diversified holdings and its weighting method, another potentially desirable aspect of the S&P 500 is its international exposure. Although all companies in the S&P 500 are based in the US, the large multinational companies included within it operate globally. This provides an element of international diversification in addition to its domestic US exposure.

S&P Features…
Before index funds, often called exchange traded funds (ETFs), mutual funds were the only way for the average investor to have a broadly diversified portfolio without buying a lot of individual stocks. Now there are ETFs that track indexes, including the S&P 500. Because the stocks included are determined by a rules-based method for inclusion, there is no need to hire a fund manager to select individual stocks. If a company within the index no longer meets the criteria of the index, it is removed, and another stock takes its place. The passive, index-based method of selecting stocks for inclusion is less costly than hiring an active fund manager to select stocks to buy and sell. Because of the potentially desirable features of the S&P 500 index, paired with the cost-effective access of ETFs that track it, S&P 500 ETFs can be a good option for the average retirement investor.

December 7, 2022