Portfolio Formation Strategies - The Capitalization - Weighted Portfolio
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What is the capitalization-weighted portfolio?

The capitalization-weighted portfolio is one of the most commonly used tools in the stock markets. It is a type 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 normally computed by adding up the shared market capitalizations of all members of the stock and then dividing it by the number of funds/ securities within the given index.

The most commonly used market indices today are what are referred to as “cap-weighted” indices, and a 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 effect 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 twisted 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 effect that is proportionate to its existing market value.

How the index value is calculated

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 get the overall value. This explains the reason why where there are many stocks with greater market value get more weight than those with lesser market value. Basically, the value will be calculated 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 get 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.

Capitalization weighted portfolio is the most popular approach to portfolio formation strategies. This is because 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 market value represents the accurate market assessment of the relative weight of firms. It is theoretically founded in the sense that it is drawn from the famous Harry Markowitz’s capital asset pricing model.

Advantages of the capitalization weighted portfolio

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 represent a buy-and-hold strategy and give broad market representation at a significantly low cost within the simulated portfolio.

Since they do not need constant rebalancing as is the case 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 have a very transparent and objective methodology that is easy to understand, build, and track.

Disadvantages of the cap-weighted portfolio

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 based on their market capitalization, it will lead to the largest securities bearing the biggest weights within the given index so much such that the role of smaller capitalization securities will be insignificantly minimal.

Understanding the total market capitalization

TMC or total market capitalization is basically a measurement of the size of a given company within the stock market as per 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 current stock price.

Based on the total market capitalization amount, the stocks of the given price will then be grouped as either big cap, mid 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 degree of volatility involved with investing in the given market.

Most people make the mistake of assuming the size of a given company is directly proportional to the stock price. As a matter of fact, a company can have a significant stock price that is just a reflection of a lack of availability of shares. Another company can have a relatively small current price because 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.

Conclusion

There are several factors that affect the total market capitalization, which will ultimately affect the capitalization weight portfolio. Basically, a company’s performance on the stock market, investor perception towards the company, and economic stability i.e. revenue making potential of the same are the major determining factors.

As an investor, you need to factor in all the indicators at your disposal to determine whether a specific company is worth investing in. Whether you choose a big cap, mid cap, or small cap, the most important things to keep in mind are the fees, commissions and management expenses that go into any particular portfolio index.



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