The S&P 500 measures the value of the stocks of the 500 largest corporations by market capitalization listed on the New York Stock Exchange or Nasdaq Composite. The intention of Standard & Poor's is to have a price that provides a quick look at the stock market and economy. Indeed, the S&P 500 index is the most popular measure used by financial media and professionals, while the mainstream media and the general public might be more familiar with the Dow Jones Industrial Average.

The S&P 500 index is a float-adjusted market-cap weighted index. It’s calculated by taking the sum of the adjusted market capitalization of all S&P 500 stocks and then dividing it with an index divisor, which is a proprietary figure developed by Standard & Poor's.

Being float-adjusted, the index is continuously recalculated based on the shares trading. The divisor is adjusted when there are stock splits, special dividends, or spinoffs that could affect the value of the index. The divisor ensures that these non-economic factors do not affect the index.

The index is calculated as follows:

SP500Index=Market Cap of All SP500 StocksIndex Divisor\text{SP500Index} = \dfrac{\text{Market Cap of All SP500 Stocks}}{\text{Index Divisor}}SP500Index=Index DivisorMarket Cap of All SP500 Stocks

S&P 500 Pitfalls

One result of this methodology is that the index is weighted toward larger-cap companies.

For example, on Dec. 17, 2018, the largest component was Microsoft at $802 billion. Compare that to the likes of Adobe, which has a $110 billion market cap. The total market capitalization of all the companies in the index was $23.3 trillion.

The weighted average market capitalization of each individual component is then determined by dividing the market capitalization of the individual component by $23.3 trillion. Microsoft’s weighting is determined by taking its market capitalization and dividing it by the total index market cap.

The formula for determining this weighting is as follows:

Weighting=Market Cap of Individual ComponentTotal Market Cap of All SP500 Stocks\text{Weighting} = \dfrac{\text{Market Cap of Individual Component}}{\text{Total Market Cap of All SP500 Stocks}}Weighting=Total Market Cap of All SP500 StocksMarket Cap of Individual Component

Therefore, using the same example, Microsoft has a 3.4% weighting, while a smaller company like Adobe has a 0.5% weighting in the index. This leads to the mega-cap stocks having an outsized impact on the index. Sometimes, this index structure can mask strength or weakness in smaller companies if larger-cap companies are diverging. In other ways, this index structure better represents the overall economy than indexes in which weighting is determined by an equal share or an index that is price weighted.

S&P 500 Positives

The S&P 500 is considered an effective representation for the economy due to its inclusion of around 500 companies, which covers all areas of the United States and across all industries. In contrast, the Dow Jones Industrial Average (DJIA) is comprised of 30 companies, leading to a more narrow reflection. Further, the DJIA is a price-weighted index, so the largest weighted components are determined by its stock price rather than some fundamental measure.

The S&P 500 is a broader representation, having more stocks and covering every industry. The DJIA is limited and the movement of a stock in the DJIA can have a greater impact than that of the S&P 500. The largest weighted stock in the S&P 500 likely has a smaller weighting than the largest weighted stock in the DJIA. The movement of a few companies can have a profound impact on the DJIA.