If you’ve ever listened to financial commentary, you’ve likely heard references to how “the market” is doing. In most cases, analysts are referring to the S&P 500 Index. But what does that actually mean, and how does it relate to your portfolio?
Created in 1957, the S&P 500 tracks 500 major U.S. companies across all 11 sectors and often serves as a broad gauge of economic health. The S&P 500 only includes large-cap companies. As part of its eligibility requirements, a company must currently have a market capitalization of $22.7 billion or more to be considered for inclusion. This is important because the S&P is a free-float, capitalization-weighted index—its components are weighted according to the total market value of their outstanding shares. The behemoth companies known as the “Magnificent Seven”—Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta, and Tesla—make up approximately 37% of the index. It’s possible that the other 499 companies could be down for the day, but an outperformance from Nvidia, with a market cap of $4+ trillion, could still push the S&P 500 into positive territory.
In contrast, the Dow Jones Industrial Average tracks just 30 U.S. companies and is a price-weighted index, where each component’s weight is determined by its nominal share price. As a result, stocks with higher share prices have more influence over the Dow’s daily movement. The Nasdaq Composite rounds out the three major indices and includes almost all stocks listed on the Nasdaq exchange. While the Nasdaq tracks more than 2,500 stocks and is also market-cap weighted, it has a heavier concentration in growth-oriented technology companies, which makes it more volatile than the S&P.
Because stock indices represent overall market performance, they are commonly used as benchmarks for mutual funds and exchange-traded funds. Index funds offer broad diversification, usually low costs because of passive management, and tax efficiency thanks to low turnover. By investing in a low-cost index fund that tracks the S&P 500, you’ll generally capture the market’s returns for that index (minus modest fees and tracking error) rather than trying to beat it.
Indices also evolve over time to reflect our changing economy. When the Dow Jones Industrial Average was first published in 1896 during America’s second industrial revolution, it tracked companies like American Cotton Oil, American Sugar, and Tennessee Coal, Iron and Railroad. Today, the Dow is dominated by Financial and Technology companies such as Goldman Sachs and Microsoft. Because of how both the S&P and Dow are constructed, they naturally favor companies that have already performed the best.
In contrast, an actively managed portfolio provides a level of risk management that passive indices cannot. While an actively managed portfolio may occasionally trail its benchmark, it may also seek to take on less risk. In this case, you shouldn’t expect outsized returns. The opposite can also be true where an active manager seeks to take on more risk than the strategy’s benchmark. When constructing a portfolio, we recommend diversification to help smooth volatility and reduce risk. While an index fund can be diversified across sectors, we also encourage investors to diversify among U.S. and international stocks, large-cap and small-cap companies, growth and value styles, and various sectors—because not all equities move in lockstep.
Just because “the market,” as represented by the S&P 500 Index, is down doesn’t necessarily mean your portfolio will be down, which is why it’s important not to judge your performance solely on what the S&P 500 did today. A well-constructed portfolio blends assets that respond differently to economic conditions, helping protect your long-term goals even when headlines are negative.
If you have questions about the composition of your portfolio, the experts at Henssler Financial will be glad to help:
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This article is for demonstrative and academic purposes and is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
