Capitalization-Weighted Index

What Is a Capitalization-Weighted Index?

A capitalization-weighted index, otherwise called a market value-weighted index, is a type of stock market index in which individual components of the index are remembered for amounts that correspond to their total market capitalization (abbreviated as "market cap").

With the capitalization-weighted method, the index components with a higher market cap will receive a higher weighting in the index. Relatively, the performance of companies with a small market cap will an affect the performance of the overall index. Different methods for computing the value of stock market indexes are the price-weighted, fundamental-weighted, and equal-weighted index construction methods.

Understanding Capitalization-Weighted Indexes

A stock market index measures a subset of the stock market and assists investors with comparing current price levels with past prices to gather data about the current market performance. It is computed utilizing different methods (counting the capitalization-weighted method) with the prices of chosen stocks.

A capitalization-weighted index utilizes a company's market capitalization to decide how much impact that specific security can have on the overall index results. Market capitalization is derived from the value of outstanding shares. The investment community can utilize market capitalization to decide a company's size, rather than utilizing sales or total asset figures.

A company's market capitalization is calculated by increasing its outstanding shares by the current price of a single share. Along these lines, market capitalization mirrors the total market value of a company's outstanding shares.

In the composition of a capitalization-weighted index, large developments in the price of shares for the largest index companies can fundamentally impact the value of the overall index. Nonetheless, since large companies with various outstanding shares will generally be more stable revenue producers, they can likewise give consistent growth to the index. Then again, small companies will generally have a lower weighting, which can reduce risk on the off chance that the companies don't perform well.

Market-cap indexes furnish investors with data about a wide assortment of companies — both large and small. Many stock market indexes are capitalization-weighted indexes, including the S&P 500 Index, the Wilshire 5000 Total Market Index (TMWX), and the Nasdaq Composite Index (IXIC).

Pundits of the capitalization-weighted indexes contend that the overweighting of the largest companies can give a twisted perspective on the market. Notwithstanding, the largest companies likewise have the largest shareholder bases, which presents a defense for having a higher weighting in the index.

Calculation of a Capitalization-Weighted Index

To find the value of a capitalization-weighted index, first increase every component's market price by its total outstanding shares to show up at the total market value. The extent of the stock's value to the overall total market value of the index components gives the weighting of the company in the index. For instance, consider the following five companies:

• Company A: 1 million shares outstanding, the current price per share equals $45
• Company B: 300,000 shares outstanding, the current price per share equals $125
• Company C: 500,000 shares outstanding, the current price per share equals $60
• Company D: 1.5 million shares outstanding, the current price per share equals $75
• Company E: 1.5 million shares outstanding, the current price per share equals $5

The total market value of each company would be calculated as:

• Company A market value = (a million x $45) = $45,000,000
• Company B market value = (300,000 x $125) = $37,500,000
• Company C market value = (500,000 x $60) = $30,000,000
• Company D market value = (1,500,000 x $75) = $112,500,000
• Company E market value = (1,500,000 x $5) = $7,500,000

The whole market value of the index components equals $232.5 million with the following weightings for each company:

• Company A has a weight of 19.4% ($45,000,000/$232.5 million)
• Company B has a weight of 16.1% ($37,500,000/$232.5 million)
• Company C has a weight of 12.9% ($30,000,000/$232.5 million)
• Company D has a weight of 48.4% ($112,500,000/$232.5 million)
• Company E has a weight of 3.2% ($7,500,000/$232.5 million)

In spite of the fact that companies D and E have equivalent amounts of shares outstanding — 1,500,000 — they address the highest and lowest weightings in the index, separately, due to the effects of their prices on their individual market values.

Benefits and Disadvantages of Capitalization-Weighted Indexes

A large number of the world's most famous benchmark indexes are market cap-weighted, making them effectively accessible to most investors to gain access to a very much diversified, broad-based portfolio. Over the long run, be that as it may, in the event that certain companies develop enough, they can wind up making up an unreasonable amount of the weighting in an index. This is on the grounds that, as a company develops, index fashioners are committed to name a greater percentage of the company to the index. These companies will quite often be less unstable, more mature, and better appropriate for most investors as core holdings. Simultaneously, this effect can jeopardize a diversified index by putting too much weight on one individual stock's performance as it comes to overwhelm the index make-up.

The Dow Jones Industrial Average (DJIA) is maybe the main index that isn't capitalization-weighted. Rather, it mirrors the sum of the price of one share of stock for every one of the components, partitioned by its proprietary Dow Divisor. In this way, a one-point move in any of the component stocks will move the index by an indistinguishable number of points.

Furthermore, index funds and exchange-traded funds buy extra shares of a stock as its market capitalization increments or as the share price increments. As such, as the stock price is rising, these funds purchase more shares at the higher prices; this can be counterintuitive to the investing mantra of buying low and selling high.

In the event that a company's stock is fundamentally overvalued (from a technical analysis point of view), the purchasing of the stock as its price (and consequently, its market cap) increments can make a bubble in the stock's price. Subsequently, purchasing stocks based on market-cap weightings can lead to a stock market bubble. In the event that the bubble were to burst, this would send stock prices into a free fall.

The S&P 500 is a capitalization-weighted index that contains probably the most deeply grounded companies in the U.S. Here is a historical real illustration of how the index worked on a specific trading day:

• On March 22, 2019, Boeing Co. (BA) closed down - 2.83% to $362.17 while Microsoft Corp. (MSFT) closed down - 2.64% to $117.05 for the afternoon.
• Boeing had a market cap of $205.39 billion and a weighting of under 1% in the S&P on that day.
• Microsoft Corp. had a market cap of $902.61 billion and a weighting of more than 3% in the S&P.
• Subsequently, Boeing's price decline smallerly affected the S&P than Microsoft's impact even however the two stocks declined by almost a similar percentage.
• All in all, Microsoft hauled the S&P down more so than Boeing for that day in light of the fact that Microsoft had a larger market cap than Boeing.

It's important to note that the weightings of the S&P 500 change daily with the companies' outstanding shares and their prices, which brings about differing impacts on the Index's overall value.

Highlights

• The components with higher market caps carry greater percentage weights in the index. Conversely, the components with smaller market caps have lower weightings in the index.
• A capitalization-weighted index is an index construction methodology where individual components are weighted according to their relative total market capitalization.
• Pundits of cap-weighted indices contend that the overweighting toward larger companies gives a misshaped perspective on the market.