Market-Capitalization Weighting (also known as “Cap-Weighting”) is a method for constructing a stock market index where individual companies are included in proportion to their total market capitalization. In simpler terms, the bigger the company’s market value, the bigger its slice of the index pie. To calculate a company's weight, you take its market capitalization (stock price x number of outstanding shares) and divide it by the total market capitalization of all the companies in the index. This is the default methodology for most of the world's best-known indices, including the S&P 500, Nasdaq 100, and the FTSE 100. When you buy a standard index fund that tracks one of these major indices, you are almost certainly buying into a cap-weighted portfolio. This means a giant like Apple Inc. will have a much greater impact on your fund's performance than a smaller (but still large) company in the same index.
Imagine we created the “Capipedia 3 Index” with just three fictional companies:
The total market capitalization of our index is $800 + $150 + $50 = $1 trillion. The weights would be calculated as follows:
If you invested $1,000 into a fund tracking this index, $800 would be allocated to MegaCorp, $150 to SolidCo, and just $50 to Upstart Inc. The performance of MegaCorp would overwhelmingly dictate the performance of your entire investment.
There's a reason cap-weighting is the industry standard. It has two compelling advantages that have made it the go-to for passive investing.
Cap-weighted indices are incredibly efficient. They are largely self-regulating; as a company’s stock price rises, its market cap and, therefore, its weight in the index automatically increase. The fund manager doesn't have to do anything. This passive nature results in very low turnover (meaning infrequent buying and selling of stocks). Low turnover is a huge plus because it leads to:
By its very design, cap-weighting ensures that you are always invested most heavily in the market's biggest success stories. As companies grow and their stocks perform well, their influence on the index increases. In essence, it’s a form of momentum investing that lets your winners run, automatically capturing the growth of the market's most dominant players.
While simple and popular, cap-weighting has some serious flaws from a value investing perspective. A wise investor should be aware of these built-in biases.
The core problem for a value investor is that cap-weighting systematically makes you buy more of a stock as its price goes up and less of it as its price goes down. This is the polar opposite of the classic “buy low, sell high” mantra. It links your investment decisions directly to market sentiment and price momentum, rather than to a company's underlying intrinsic value. When a sector or a specific stock becomes a market darling and gets bid up to irrational prices, a cap-weighted index obediently buys more and more, effectively forcing you to participate in potential bubbles.
While an index like the S&P 500 contains 500 stocks, it is often far less diversified than it sounds. Because of cap-weighting, a handful of mega-cap stocks at the top can dominate the index's performance. At various times, the top 10 companies have accounted for over 30% of the S&P 500's total value. This concentration risk means that if just a few of these giants stumble, they can pull the entire market down with them. History is littered with examples where this concentration hurt investors, from the crash of the Nifty Fifty stocks in the 1970s to the bursting of the dot-com bubble in 2000.
As Warren Buffett famously notes, “Price is what you pay; value is what you get.” A company's market capitalization is a measure of its price, not its fundamental worth. It tells you how popular and expensive a company is, but it tells you nothing about its profitability, sales, book value, or debt levels. A cap-weighted strategy is, by definition, indifferent to valuation. It will allocate the most capital to the most expensive stock, regardless of whether it's a fantastic business or a house of cards.
For investors uncomfortable with the idea of “buying what's popular,” there are other ways to construct an index: