The capitalization-weighted portfolio is among the most commonly used instruments in the stock markets. It is a form of stock market index where individual components of the stock are weighted / valued as per their market capitalization.
This means that larger components will carry more weight than smaller components. The value of a capitalization weighted portfolio is usually computed by adding up the shared market capitalizations of all states of the stock and then dividing it by the number of funds / securities within the given index.
And, of course, we must also consider….
This weighting algorithm differs a great deal from the weighting algorithm most commonly used by portfolios and funds where stocks are weighted as per their market capitalizations. As a result, the equally weighted portfolio will have a greater stock turnover compared to a market-cap weighted index portfolio, hence will have a considerably higher trading cost.
Stock Market, are you kidding?
In relation to general investment, equal weight basically refers to the practice of putting the same degree of importance on each security that makes an investment portfolio or index fund. This approach allows you the investor to look at the stocks at your disposal without taking into account the actual extent of the company or a company’s market share. The equally weighted portfolio doesn’t be based on the market capitalization that is usually the case with other weighting approaches, as such.
The greatest advantage of the equally weighted portfolio is the fact that an investor is exposed to great and lucrative investment opportunities that may be underplayed when using other portfolio formation strategies. For instance, if the stocks of a given universe are evaluated based on the price, an investor is liable to get lucrative stocks to invest in, but can easily miss out on other lucrative deals by companies that aren’t within the same range when a price-weighted portfolio is used.
The most commonly used market indices today are what are referred to as ‘cap-weighted ” indices, and a very good example of these include Hang-Seng, Wilshire, Nasdaw, S&P 500 and EAFE indexes to mention but a few. In this strategy, large price moves in the largest shares can have a huge impact on the value of the given index, and vice versa.
Some pundits in the investment world feel that this overweighting toward the large companies gives a distorted view of the market. However, the fact that these giant corporations have the biggest shareholder numbers makes the case because it provides more relevance within the given index. Basically, each stock within the capitalization-weighted index will have an impact that is proportional to its existing market value.
Because each stock component contributes to the overall index value, it means all the stock components would need to be factored in so as to obtain the overall value. This explains the reason that where there are a number of stocks with greater market value get more weight than those with lesser market value. Basically, the value will be determined by multiplying the total number of outstanding shares by the stock price.
The sum of the value of all the component stocks will then be divided by an index divisor so as to obtain the final index value. Note that the index divisor in capitalization weighted portfolio is a random number that is first defined immediately the index is published.
Stock market indexes gauge the performance of a particular area of investments. In America, the Dow Jones Industrial Average, Nasdag Composite Index, and S&P 500 are the three primary stock market indexes. The Dow and S&P 500 are composed of large capitalization stocks, such as Proctor & Gamble, Bank of America, Wal-Mart, and ExxonMobil. Alternatively, the Nasdaq Composite Index largely tracks the technology economy, as it is made up of stocks such as E-Bay, Google, and Apple Computer. Your portfolio of U.S. stocks is liable to be making money on days when the Dow, S&P 500, and Nasdaq are all up by more than one percent.
The stock ticker stream price quotes for stock market indexes and individual stocks throughout the day. For individual stocks, the stock ticker stream starts with a ticker symbol, before it presents the price of the stock’s last trade and its daily change in market value. You will visit a corporation’s official website, then click on the investor relation’s tab, for ticker symbol information. To monitor the stock ticker and various price quotes, you can watch CNBC, or look up data through Yahoo! Finance.
Capitalization weighted portfolio is the more popular approach to portfolio formation strategies. This is as it is a practical, objective and theoretically founded weighting scheme. It is practical in the sense that a portfolio will automatically adjust its stock constituents weight as the prices move, thus leading to fewer rebalancing trades.
It is objective in the sense that the contract value represents the accurate market evaluation of the relative weight of firms. It is theoretically founded in the sense that it’s drawn from the famous Harry Markowitz’s capital asset pricing model.
Weighting the stock constituents of any given index, based on their market capitalization, has so many practical benefits that are attractive to investors. Basically, these are the only indices that constitute a buy-and-hold strategy and give broad market representation at a significantly low cost within the simulated portfolio.
Since they don’t need constant rebalancing as is happening with the equally weighted portfolio, capitalization weighted portfolio helps keep transaction costs to the minimum within the simulated portfolio. The other notable advantage is the fact that they’ve got a very transparent and objective methodology that is easy to see, build, and track.
Like all other portfolio formation strategies, the cap-weighted portfolio also has its share of disadvantages. Critics generally point to the fact that when an index’ constituent’s weight is depending on their market capitalization, it will result in the largest securities bearing the biggest weights within the given index so much such that the function of smaller capitalization securities will be insignificantly minimal.
TMC or total market capitalization is essentially a measurement of the magnitude of a given company within the stock market according to the value of its shares outstanding. In order to calculate the TMC of a given company, the amount of shares outstanding is multiplied by the present stock price.
Based on the total market capitalization amount, the stocks of the given price will then be grouped as mid cap, either big cap, or small cap, with clearly defined differences within the groupings. These three classifications help an investor know how large or small, thereof, a company is, and the extent of volatility involved with investing in the given market.
Most people make the error of assuming the magnitude of a given company is directly proportionate to the stock price. A company can have a considerable stock price that is only a reflection of a shortage of availability of shares, as a matter of fact. Another company can have a relatively small current price as a result of an excessive amount of shares available to investors for buying. One of the best indicators of a given company market’s standing is the total market capitalization.
There are a number of factors which affect the total market capitalization. This will finally affect the capitalization weight portfolio. Basically, a company’s performance on the stock exchange, investor perception towards the company, and economic stability I.e. revenue making possibilities of the same, are the main determining factors.
You need to factor in all the indicators at your disposal to decide whether a specific company is worth investing in, as an investor. Whether you choose mid cap, a big cap, or small cap, the most important things to bear in mind are the fees, commissions and management expenses that go into any particular portfolio index.