Here’s why I like market-cap-weighted indexes
Did you know that not all market indexes are created equal? There are three standard methodologies for creating an index: market-cap-weighted, price-weighted, and equal-weighted.
The S&P 500 and Nasdaq Composite are market cap-weighted. The Dow Jones Industrial Average is price-weighted. You’re probably not familiar with any of the equal weight Indexes or ETFs, but here’s one: the Invesco S&P 500 Equal Weight ETF (RSP).
Market-cap-weighted (or “cap-weighted” for short) indexes put the most weight on the largest companies. The logic is intuitive and goes something like this: The largest companies on the planet are the most representative of the economy. The profits of Walmart, Amazon, Apple, Google, Visa, Berkshire Hathaway, Johnson & Johnson, and other giants are more representative of the economy’s health than the earnings of much smaller companies.
Their size and disproportionate impact bring more stability to the Index and arguably less risk. By placing more weight on the largest companies, the S&P 500 effectively “rewards” companies that thrive by punishing those that don’t. In that sense, the Index automatically adds to winners while reducing exposure to losers.
In a world where some 44% of all companies end up suffering catastrophic losses (see yesterday’s Tackle Today blog), it seems to me that crafting an index that continually focuses on upping exposure to the winners while weeding out the losers is smart.
Chart of the Day
Top Ten Holdings of S&P 500
The top ten holdings of the S&P 500 changes as stock prices fluctuate, but one of the crazier developments in recent memory was Tesla being added after its market cap had grown beyond 495 of the 500 stocks already in the Index.
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