Module 1

What is a stock market index?

Lesson 4

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Although investors can buy shares (ownership interests) in individual companies like Apple or Facebook, there are several ways to buy a basket of stocks representing ownership in hundreds of companies.  One way to buy an ownership stake in a broad array of companies is to buy an Index fund.

Index funds can be constructed in many different ways (most rely on a simple set of rules to choose a basket of dozens or hundreds of stocks), though the most popular index for investing in U.S. listed stocks is known as the S&P 500.  The S&P 500 index represents ownership in a diversified mix across industries of 500 of the largest companies traded in the United States.  When people say “the market was up (or down) today” or my investments “beat the market,” they are usually referring or making comparisons to the returns of the S&P 500 index.

The S&P 500 index does not buy an equal amount of all 500 stocks in the index (for an investment of $1000, an equal amount invested in all 500 companies would mean an investment of $2 in each).  Instead, the larger a company’s total market value, the larger weight that company gets in the index.  As a result, the S&P 500 index is known as a market-weighted index.

For example, at this writing, Apple is the largest company (as measured by its total market value) within the S&P 500 index.  If you invested $1000 in the index, you would own a small amount of all 500 stocks in the index but the weights in each would be unequal.  Since Apple has the largest market value (close to $2 trillion), its weight in the index is the largest at about 6.5%.  That means, for each $1000 you invest in the S&P 500 index, you would own approximately $65 worth of Apple stock.  Though the smallest company in the S&P 500 (currently, Coty Inc.)  still has a market value of over $2.6 billion, for each $1000 you invest in the S&P 500 index, you would own less than 10 cents worth of that company.

There are many different types of indexes (and we will discuss a number of them), but a market-weighted index like the S&P 500 index provides a very useful representation of how the stock market as a whole is performing.  Investing in this index is a great way to participate in the overall growth of many of our country’s largest and best businesses.

Glossary of Terms

An index fund is a type of mutual fund with holdings (anything from stocks to bonds to options to futures) that follow a certain market index. An index fund is a passive investment strategy, allowing you to build a portfolio and earn returns in a hand-off way.

The S&P 500 index represents ownership in a diversified mix across industries of 500 of the largest companies traded in the United States. When people say “the market was up” or “my investments beat the market,” they’re usually referring to or comparing to the return of the S&P 500.

The S&P 500 index is known as a market-weighted index. This just means that the S&P 500 index doesn’t buy an equal amount of all 500 stocks in the index. Instead, the larger a company’s total market value, the larger weight that company gets in the index.