Show pageOld revisionsBacklinksBack to top This page is read only. You can view the source, but not change it. Ask your administrator if you think this is wrong. ====== Market-Capitalization Weighting (Cap-Weighting) ====== 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. ===== How It Works: A Simple Example ===== Imagine we created the "Capipedia 3 Index" with just three fictional companies: * **MegaCorp:** Market Cap = $800 billion * **SolidCo:** Market Cap = $150 billion * **Upstart Inc.:** Market Cap = $50 billion The total market capitalization of our index is $800 + $150 + $50 = $1 trillion. The weights would be calculated as follows: * **MegaCorp Weight:** $800 billion / $1 trillion = 80% * **SolidCo Weight:** $150 billion / $1 trillion = 15% * **Upstart Inc. Weight:** $50 billion / $1 trillion = 5% 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. ===== The Big Appeal: Why Is It So Popular? ===== 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. ==== Simplicity and Low Cost ==== 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: * **Lower Trading Costs:** Fewer trades mean fewer brokerage commissions. * **Better Tax Efficiency:** Fewer sales mean fewer [[capital gains]] distributions, which are taxable events for investors holding the fund in a non-tax-sheltered account. ==== Riding the Winners ==== 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. ===== The Value Investor's Critique ===== 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. ==== A Recipe for Buying High? ==== 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. ==== The Peril of Concentration Risk ==== 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. ==== Price Is Not Value ==== 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. ===== Smarter Alternatives to Consider ===== For investors uncomfortable with the idea of "buying what's popular," there are other ways to construct an index: * **[[Equal Weighting]]:** In this model, every company in the index gets an equal share of the pie. The 500th company in the S&P 500 would have the same weight as the 1st. This method provides greater exposure to smaller companies and avoids the concentration risk of cap-weighting, though it requires more rebalancing. * **[[Fundamental Weighting]]:** This approach weights companies based on fundamental business metrics like sales, cash flow, dividends, or earnings, rather than market price. Pioneered by thinkers like [[Rob Arnott]], this strategy attempts to anchor a portfolio to a company's real economic footprint. It is inherently more aligned with the principles of value investing.