FINANCIAL TOOL
Capitalization-Weighted Index
A market index tracks a subset of the total stock market, based on its pre-defined parameters.
The most popular indexes for the US stock market are the S&P 500, the Dow Jones and the NASDAQ-100. But not all are weighted the same way. The Dow Jones is price-weighted, whereas the S&P 500 and NASDAQ-100 are cap-weighted.
What does that mean?
There are different ways to track a group of stocks.
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- For example, should all stocks make up an equal percentage of the total index? That might give too much influence to smaller companies and be less indicative of the total US economy.
- Or should the bigger companies take up more space within the index, since they clearly are driving greater economic activity?
- Or should we make things simple and just include the equivalent of one stock per company in the index, therefore giving more influence to the highest priced stocks (which is somewhat arbitrary due to the ability for stocks to split).
There’s no right or wrong way to do this. All have their own weaknesses and strengths.
But it’s important to know how an index is weighted in order to manage risk appropriately to your intended outcome.
The S&P 500, the NASDAQ-100, and the Russell 3000 are popular capitalization-weighted indexes on the US market. That means mega companies with the highest market capitalization (calculated as price x outstanding shares) drive the majority of the index’s returns.
That can be important to know, because early bull markets often see strong returns in only a handful of stocks (often mega cap stocks), whereas the returns spill over into broader sectors of the market as investor confidence resumes and FOMO (fear of missing out) kicks in.
But because cap-weighted indexes concentrate significantly in the few largest companies, an investor in such an index tracker could easily miss out on the growth of small- and mid-sized companies that are riding the new wave of economic activity.
Unless there’s reason to make bets on these largest companies, then spreading the risk a bit more evenly across companies could reduce concentration risk (unsystematic risk) without significantly impacting expected return.