A value-weighted index distributes proportionally to the market cap of each company. The larger the capitalization, the more influence it has on the portfolio.
The Value-Weighted Index Explained
To better understand the concept, break it down:
- An index is a hypothetical portfolio of investments that represent part of the market
- Value weighted means that the investment amount is proportional to the market capitalization. Large-cap companies influence the price more than micro-caps
In combination, a value-weighted index is an investment portfolio that represents the market based on market capitalization. Examples of these are the S&P500, NASDAQ composite, and the FTSE 100.
For the investor, indexes allow to minimize risk through diversification:
Suppose you invest in an index fund that includes ten companies with the same capitalization. Within a value-weighted index, each of these companies has the same impact on price.
Suppose your fund instead has six companies, but one of them represents 50% of the total market cap. Instead of being 1/6th of your portfolio, it affects half of it.
What Does Make a Value-weighted Index Useful?
Large-cap markets tend to have long-term growth and minimal loss risk. Small-cap markets change prices fast, and they’re typically influenced by larger caps.
Imagine you split your value-weighted index into two groups:
- The first 50% is for one or two large companies (long-term strategy)
- The other 50% goes for dozens of micro-cap companies (short-term strategy)
When small-cap companies depreciate, large-cap companies protect your portfolio (as they’re not easy to take down). The problem is, these giants will not earn you much profit.
Micro-cap companies, however, use volatility to grow faster. And the more of these you have in your portfolio, the more chances you have to find the one that skyrockets.
In short, you’re getting higher returns while lowering risk.
Pros & Cons Of The Value-Weighted Index
Investing in capitalization-weighted index funds is safe because it sticks to the general market trend. While that questionable as a benefit, it’s certainly less volatile.
When you have stability, you have the freedom to invest in riskier companies that might bring better returns. If things don’t go as expected, your large-cap companies will minimize the loss.
It’s common to misunderstand diversification as just having more companies in your portfolio. This strategy can still fail you if:
a. You have an unbalanced asset allocation
b. Your investments are all correlated
c. You over-diversify, lowering your ROI
It can protect wealth in a crisis, but it won’t make you rich. When investing in value-weighted indexes, their price depends on whatever company has the largest market cap.
Suppose you have a company representing 90% of your portfolio market cap. It doesn’t matter if you have 200 companies as the other 10%. If the big one drops by 50%, you lose nearly half of your money.
As for growth, you won’t see indexes appreciate by 100% or 50% overnight. If you want to find opportunities, you might want to skip indexes and diversify by yourself.
Indexes are about diversification. Having hundreds of securities allows you to capture most opportunities. For a cost.
Every asset you add to the portfolio reduces your profits (unless they’re all correlated, which isn’t diversified. To make money, you need all of them to appreciate at the same time. That is if the economy improves.
Luckily, the markets have always appreciated over the decades. This makes value-weighted stocks a useful strategy, whether you’re investing long-term or short-term.
The index may not represent the investments you care about. In the case of the S&P500, it has hundreds of companies that you’d rather skip.
Just like getting more opportunities can get you money, more investments can counter the profits you earn. Especially when you don’t know what you’re buying.
Most people don’t know what are the top 10 companies in the S&P500. And they’ve been holding for years.
While indexes can protect your money, it doesn’t get close to what you can earn with other investment vehicles.
Suppose there’s a new company that’s doing great this year. If you’re one of the early investors, you can make great returns.
Sadly, index fund investors will miss it:
- You depend on the manager’s criteria, whether they decide to add it or not
- Before adding it to the fund, you have to wait 6-12 months after the initial public offering (IPO)
By the time you buy that company, it has already pumped. And if you keep the index fund, you’ll buy it at peak price.
PRO: High reference value
Capitalization indexes can accurately show where the economy is heading. So while they might not be the best performers, they help with market predictions.
As long as the capitalization increases, there will be an uptrend.
For example, you can compare your investment with the S&P500. If it’s performing below the average, it could be an underpriced asset. If it is above the average, it will likely bounce back down.
Of course, indexes are generalizations. When a security trades below or above the average, research the company as well.
CON: You buy high
Generally, price increases correlate with capitalization.
Value-weighted index funds buy investments when their market cap increases, and they sell when it lowers. If prices follow the same pattern, you’re selling low and buying high. The perfect formula for disaster.
If you want to make money in this model, you’d need to buy the low caps. The problem is:
- The index may not consider most low-market-cap stocks
- Even if you buy a dozen of these companies, it’s still not significant enough to impact your index returns
When the fund manager buys high from all investor accounts, that will increase prices too. But since most assets have large caps, the growth won’t be noticeable.
In the event of capitalization loss, everyone holding the index fund will sell, causing a crash. Are you ready for the next recession?
Investing is about outperforming the competition. How can you expect to stand out when everyone is doing the same?
The Bottom Line
While indexes do great at managing risk, they severely limit short-term returns. Whether that’s desirable or not depends on your goals.
The value-weighted index generalizes how the economy is doing. It only makes sense to invest in these securities if you believe the general markets are going to do well.
If you’re willing to wait a long time, you will see good returns, as the market has shown for decades. But that doesn’t mean you cannot lose money in an index fund.
If you’re looking for the right investment plan for you, you might need to look outside of index funds. Rather than picking whatever earns the most, choose the fund that fits your goals and investing style.