The weighted average market capitalization refers to a type of stock market index construction that is based on the market capitalization of the index’s constituent stocks. Large companies therefore account for a greater portion of an index than smaller stocks. This means the movement of an index would depend on a small set of stocks.
The most well-known market capitalization weight index is the S&P 500, which tracks the 500 largest assets by market capitalization. For instance, the top four holdings combine for over 10% of the entire index. These include Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), and Meta (formerly Facebook) (META). The S&P 500 is widely considered a gauge of the strength of the broader market and a benchmark for performance.
Key Takeaways
- Market Cap Weighting: Weighted average market capitalization is a stock market index in which each component is weighted according to the size of its total market capitalization.
- Market Strongholds: Market capitalization is defined as the sum of the total value of a company’s outstanding shares multiplied by the price of one share.
- Impact on Indices: Components with a higher market cap have more influence because they constitute a higher percentage in the index; those with smaller caps have less influence.
- Stability and Realism: A weighted market cap index is seen as both stable and reflective of the broader market, as larger companies generally have a greater influence than smaller ones.
- Risk-performance Dynamics: However, a weighted market cap index can limit returns for index investors when smaller-cap stocks rally, as opposed to an equal-weighted index.
Understanding the Weighted Average Market Capitalization
The weighted average market capitalization is determined by multiplying the current market price by the number of outstanding shares and then taking an average to determine the weighting. For example, if a company’s market capitalization is $1 million, and the market capitalization of all stocks in the index is $100 million, the company would represent 1% of the index. Different providers calculate the metric variously; Morningstar uses a geometric mean, whereas others use an arithmetic mean.
Some investors believe that weighted average market capitalization is the optimal method of asset allocation as it mirrors actual market behavior. Larger companies naturally have a greater influence over the index, akin to how the S&P 500 operates. This also introduces a natural rebalancing mechanism, as growing companies enter the index while shrinking ones exit. Investors argue that this methodology carries less risk since a larger portion of the fund is invested in stable companies.
However, there are drawbacks. Small-cap stocks have historically outperformed larger counterparts, giving less opportunity for index investors to gain high returns. While market-cap-weighted indexes like the S&P 500 can appear diversified, they are often heavily influenced by a few stocks, which aligns with the efficient market hypothesis that suggests stock prices reflect all available information and trade at fair market value.
Exploring Alternatives to Weighted Average Market Capitalization
Other asset allocation methods include price weighting and equal market cap weighting. A price-weighted index, like the Dow Jones Industrial Average, derives its holdings from a simple mathematical average of several stock prices.
Conversely, an equal-weighted index assigns the same weight to each stock in a portfolio or fund. The S&P 500 Equal Weight Index is an example, offering an equal-weighted version of the popular market-cap-weighted S&P 500.
Related Terms: market capitalization, S&P 500, efficient market hypothesis, Dow Jones Industrial Average.
References
- S&P Global. “S&P Global LargeMidCap(JPY) Factsheet”.
- Morningstar. “Average Market Capitalization”.
- Nasdaq. “Understanding the DJIA: How Price-Weighted Index Performance Attributions Differ From Cap-Weighted”.
- S&P Global. “S&P 500 Equal Weight Index”.
