Market-Capitalisation Weighted Index

• The Bottom Line: A market-cap weighted index is an investment portfolio on autopilot, where the biggest and most popular companies always get the largest share, forcing you to systematically buy what's already expensive while potentially ignoring undervalued gems.
• Key Takeaways:
• What it is: An index, like the S&P 500, where each company's influence is determined by its total market value (share price multiplied by the number of shares). Bigger companies move the index more.
• Why it matters: This method automatically overweights popular, potentially overvalued stocks and underweights unpopular, potentially undervalued ones, creating concentration_risk and forcing you to follow the herd. mr_market.
• How to use it: While flawed, it's a very low-cost and simple way to gain broad market exposure, and it serves as the essential benchmark against which a value investor measures their own stock-picking success.

Imagine a large, circular raft designed to carry 500 people across a lake. This raft represents an index like the S&P 500. Now, imagine that each person's weight determines how much they can tilt the raft. On this raft, you have a few enormous, 800-pound sumo wrestlers, a couple of dozen 250-pound football players, and hundreds of people of average weight. When one of the sumo wrestlers shifts their weight just a little, the whole raft tilts dramatically. But if one of the average-sized people jumps up and down, the raft barely wobbles. A market-capitalisation weighted index works exactly like this. The “weight” of each company isn't its physical size, but its market capitalisation (or “market cap”)—a fancy term for its total value on the stock market. You calculate it with a simple formula: `Market Capitalisation = Current Share Price x Total Number of Outstanding Shares` In an index like the S&P 500, companies like Apple and Microsoft are the 800-pound sumo wrestlers. Their market caps are in the trillions of dollars. When their stock prices move even a small amount, they tilt the entire index. Meanwhile, the 500th company in the index is an average-sized person; its stock could double in price, and the overall index would barely register the change. So, when you hear that “the S&P 500 was up 1% today,” it doesn't mean all 500 companies went up. It's more likely that the handful of giants at the top had a good day, dragging the average up with them. This is the most common way stock market indexes are constructed, from the Dow Jones Industrial Average ¹⁾ to the NASDAQ 100 and the UK's FTSE 100.

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” - Benjamin Graham

This famous quote from the father of value investing perfectly captures the essence of a market-cap weighted index. It is a pure “voting machine,” reflecting popularity and market sentiment. It measures which companies the crowd is currently voting for with their dollars, not necessarily which companies have the most substance (the “weight” of true business value).

For a disciplined value investor, understanding the mechanics of a market-cap weighted index isn't just academic—it's fundamental. It exposes a deep philosophical conflict with the core tenets of value investing. Believing in value investing while blindly following a market-cap index is like being a nutritionist who only eats at fast-food chains. Here’s why it's so critical. 1. It's a Momentum-Chasing Machine Value investing is built on a simple, powerful idea: buy low, sell high. You seek out excellent businesses that Mr. Market, in his pessimism, has marked down to a bargain price. A market-cap index does the exact opposite. By design, its formula forces it to buy more of a company's stock as its price goes up, and sell it as its price goes down.

• When a company's stock price soars, its market cap increases. To keep the index's proportions correct, index funds must buy more of that stock.
• When a stock price falls, its market cap shrinks. Index funds are forced to sell shares to reduce its weighting.

This is a built-in mechanism for “performance chasing.” It systematically allocates more capital to whatever is fashionable and expensive, and less to whatever is neglected and cheap. This is the very definition of following the herd, a behaviour that value investors like Warren Buffett have spent their careers avoiding. It directly contradicts the principles of contrarian_investing and buying with a margin_of_safety. 2. It Creates the Illusion of Diversification One of the main selling points of an index fund is diversification. You own 500 stocks, so you must be safe, right? Not necessarily. Because of the market-cap weighting, the top 10 companies in the S&P 500 can often account for over 30% of the entire index's value. In recent years, a handful of giant technology stocks have become so large that their performance essentially is the market's performance. This creates immense concentration_risk. If you believe you are diversified across the entire U.S. economy, you might be unpleasantly surprised to find that your portfolio's fate is tied to the quarterly earnings reports of just five or six mega-cap tech companies. A true value investor seeks diversification across industries, business models, and sources of risk, not just a long list of company names dominated by a few giants. 3. It Glorifies Price Over Intrinsic Value This is the most crucial point. A market-cap weighted index is completely agnostic about value. It has no opinion on a company's debt, its profit margins, the quality of its management, or its long-term competitive advantages. Its sole criterion for a company's importance is its market price, as determined by the collective, often emotional, whims of millions of traders. A company could be trading at 100 times its earnings, drowning in debt, and facing existential threats, but if its stock price is high, the index will give it a massive weighting. Conversely, a wonderfully profitable, debt-free business with a dominant market position could be trading at a ridiculously low price, and the index will afford it a tiny, insignificant weighting. For a value investor, this is heresy. The entire discipline is based on the idea that price and value are two different things. We spend our time trying to exploit the gap between a fluctuating market price and a company's durable intrinsic_value. The market-cap index, by its very nature, ignores this gap exists.

While a value investor should be deeply skeptical of the philosophy behind market-cap weighting, it remains an indispensable tool in three practical ways.

1. 1. Use It as Your Ultimate Benchmark: The S&P 500 (or a similar market-cap index) is the “par for the course” in investing. The entire goal of active value investing is to generate returns superior to what you could achieve by simply buying a low-cost index fund and doing nothing. If your hand-picked portfolio of undervalued stocks cannot beat the mindless momentum-chasing of the index over a long period (5-10 years), you must honestly ask yourself if your efforts are worthwhile. It keeps you honest and provides a clear yardstick for success.
2. 2. Use It as a Core Holding (The Buffett Concession): Warren Buffett has famously advised that most individual investors who don't have the time or temperament for deep business analysis should simply put their money in a low-cost S&P 500 index fund. Why? Because while it's a flawed instrument, it's less flawed than the alternatives for a passive investor. It guarantees you the market's return, prevents you from making disastrous emotional decisions (like chasing hot stocks or timing the market), and does so at a rock-bottom cost. For a value investor, it can serve as the stable, “do-nothing” core of a portfolio, around which you build a satellite of your carefully selected individual stocks.
3. 3. Use It as a Contrarian Idea Generator: A more advanced technique is to use the index as a source of what not to do. You can screen for companies within the S&P 500 whose weightings have shrunk dramatically. These are the businesses Mr. Market has punished. While many will be genuine duds, this list of the unloved and unwanted is precisely where a value investor should start their treasure hunt. Similarly, looking at the smallest 10% of companies in the index can reveal businesses that are ignored by the market's obsession with the giants at the top.

Let's create our own tiny, two-stock index, the “Capipedia 2,” to see the mechanics in action. Our index consists of two companies:

• Giants of Tech Inc.: A massive, popular technology firm.
  • Share Price: $400
  • Shares Outstanding: 5 billion
  • Market Cap: $400 x 5 billion = $2 Trillion
• Steady Savers Bank Corp.: A solid, profitable, but less glamorous bank.
  • Share Price: $100
  • Shares Outstanding: 2 billion
  • Market Cap: $100 x 2 billion = $200 Billion

Calculating the Index Weightings: First, we find the total value of our index: `Total Index Value = $2 Trillion + $200 Billion = $2.2 Trillion` Next, we calculate the weight of each company:

• Giants of Tech Weight: ($2 Trillion / $2.2 Trillion) = 90.9%
• Steady Savers Bank Weight: ($200 Billion / $2.2 Trillion) = 9.1%

Right away, you can see the extreme concentration. Even though we have two stocks, our index's performance will be almost entirely dictated by Giants of Tech. Seeing the Impact of Price Changes: Let's say both companies have a great day, and their stock prices each rise by 10%.

• Giants of Tech's 10% gain contributes `10% x 90.9%` = +9.09% to the index's return.
• Steady Savers Bank's 10% gain contributes `10% x 9.1%` = +0.91% to the index's return.

The total index return is `9.09% + 0.91% = 10%`. But look at where the return came from! The sumo wrestler did all the work. The Value Investor's Lens: Now, what if your analysis showed that Giants of Tech was wildly overvalued at $400/share, trading at 50 times earnings, while Steady Savers Bank was a bargain, trading below its book_value and paying a hefty dividend? The market-cap weighted index doesn't care. It forces you to put $10 into Giants of Tech for every $1 you put into Steady Savers. A value investor would do the opposite, perhaps avoiding the overpriced tech giant entirely and making a large, concentrated bet on the undervalued bank. This example clearly illustrates the fundamental conflict between price-agnostic indexing and value-conscious investing.

• Extremely Low Cost: Passively managed index_fund and ETFs that track these indexes have razor-thin expense ratios, often a fraction of what actively managed funds charge. This is a massive, permanent advantage.
• Simplicity and Ease of Use: It offers a “one-and-done” solution for investors seeking broad exposure to the stock market without having to research and select individual companies.
• Tax Efficiency: Because index funds don't trade frequently (low turnover), they tend to generate fewer taxable capital gains distributions for investors holding them in taxable accounts.
• Beats Most Professionals: Over the long term, the vast majority of highly paid active fund managers fail to outperform their market-cap weighted benchmark index, especially after fees.

• Inherently Pro-Bubble: The index's weighting in a hot sector automatically increases as a bubble inflates. It was heavily weighted towards tech stocks in 1999 right before the crash, and financial stocks in 2007 before the financial crisis. It has no defensive mechanism.
• Completely Ignores Valuation: As discussed, the index makes no distinction between a cheap stock and an expensive one. It is a pure momentum instrument, not a value-finding one. This is its single greatest weakness from a value investing perspective.
• False Sense of Security: The term “diversification” can be misleading. Owning 500 stocks provides little benefit if the top 10 drive 90% of the returns (and the risk).
• Forced and Inefficient Trading: Index funds are forced to buy stocks when they are added to the index and sell them when they are removed. This predictable, forced trading can be exploited by other market participants, potentially creating a drag on performance.

• intrinsic_value
• margin_of_safety
• diversification
• concentration_risk
• mr_market
• index_fund
• equal_weight_index ²⁾