A:

The Standard & Poor's 500 Index is the most commonly used benchmark for determining the state of the overall economy. Many investors also use the S&P 500 as a benchmark for their individual portfolios.

The Dow Jones Industrial Average used to be the main gauge of economic health for the United States, but that index only contains 30 companies and is limited in the sectors it represents. The S&P 500 has become the leading stock index due to its broader scope. Many hedge funds compare their annual performance to the S&P 500 – seeking to realize alpha in excess of the index's returns.

Advantages of Using the S&P 500 as a Benchmark

The central advantage of using the S&P 500 as a benchmark is the wide market breadth of the large-cap companies included in the index. The index can provide a broad view of the economic health of the United States.

In addition to its broad scope, another advantage of the S&P 500 is that components of the index are updated on a quarterly basis. A committee determines which companies to include in the index. The factors considered include a market capitalization in excess of $6.1 billion, a public float of at least 50 percent, headquarters in the U.S., adequate liquidity and financial viability.

Companies must have traded for six to 12 months after their initial public offerings (IPOs) before being considered for inclusion in the index. By updating the index components, the index can accurately reflect the state of the large-cap market.

Disadvantages of Using the S&P 500 as a Benchmark

There are also some disadvantages to using the S&P 500 as a benchmark for individual portfolio performance. Most investors are widely-diversified in assets other than stocks, such as bonds, precious metals and cash – the values of which are not reflected in the S&P 500.

Also, the index contains only larger market cap companies from the United States. In contrast, investors may own small-cap or foreign companies in their portfolios. Using the S&P 500 as a benchmark may be an inaccurate measure of portfolio return for individual investors.

Another drawback to using the S&P 500 for benchmark purposes is that the index is disproportionately weighted toward larger companies. The top 50 companies by market capitalization account for more than half of the index's value. As a result, these 50 companies have a larger impact on the calculation of the index. Sharp price movements in the larger companies have an undue influence on the overall index.

The S&P 500 uses a weighted market capitalization for its construction. The index takes the number of shares multiplied by the current market share price to determine the market capitalization for each company. All the market capitalizations are then added together and then divided by a number known as the index divisor. The result of that calculation is the index value.

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