What is the “point” (purpose) of the S&P 500?

Question

I've long wondered about the philosophy behind the selection of stocks in the S&P 500.

I've assumed that it was intended as a market indicator, with the selection being those that best paralleled the market as a whole, but many mutual funds are based on it, and many others are compared to it. This would indicate that the selection method chooses stocks that are doing better than the market as a whole.

As an example of what I'm puzzled about, if one stock in the S&P500 were to suddenly skyrocket, then if the S&P500 goal is to have the best mix of stocks, then it would be kept in the 500, but if their goal is to have the most representative mix of stock, it would have to be replaced.

What does S&P do in such a case?

Answer 1

I hate to point to Wikipedia as an answer, but it does describe exactly what you are looking for...

The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock market exchanges; the New York Stock Exchange and the NASDAQ.

The components of the S&P 500 are selected by committee... The committee selects the companies in the S&P 500 so they are representative of the industries in the United States economy. In addition, companies that do not trade publicly (such as those that are privately or mutually held) and stocks that do not have sufficient liquidity are not in the index.

The S&P is a capitalization weighted index. If a stock price goes up, then it comprises more of the total index. If a stock goes down, it comprises less, and if it goes down too much, the committee will likely replace it.

So to answer your question, if one stock were to suddenly skyrocket, nothing would happen beyond the fact that the index was now worth more and that particular stock would now make up a larger percentage of the S&P 500 index.