Advertisement

Market cap weighting

If an index is weighted by market cap (market capitalisation – the number of shares outstanding multiplied by the share price), it means the companies in the index are ranked by stockmarket value.

If an index is weighted by market cap (market capitalisation the number of shares outstanding multiplied by the share price), it means the companies in the index are ranked by stockmarket value. Most of the major global equity indices though not all of them are weighted in this way.

So, for example, in the FTSE 100 index right now, oil major Royal Dutch Shell is the top stock, with a market cap of around £169bn, while right at the bottom is subprime lender Provident Financial, with a market cap of £3.5bn or so. In effect, as a stock becomes more popular as its share price goes up it rises in the index, and as it loses fans its share price falls it drops down the index.

Advertisement - Article continues below

In theory, this is a far from sensible way to invest in a market. If you passively track a market-cap-weighted index, then you are putting the majority of your money into the most popular stocks, and as a company becomes less popular you sell out of it. That's the opposite of the "buy low, sell high" mantra.

Also, it means your portfolio is far more heavily weighted to certain stocks and sectors than you might think. For example, a FTSE 350 tracker might give the impression that you own 350 stocks, but in practice, about 7.5% of your money will be in Shell alone, and nearly 40% of your money in the top ten stocks. So there are some reasonable objections to using a "vanilla" passive fund.

However, in practice, despite these flaws, market indices still beat the majority of actively managed funds. That means that you have to have a very good reason to opt for an active fund over a simple, cheap tracker or exchange-traded fund. If you do opt for an alternative, then make sure that before you buy in you understand exactly what the fund does, and why it claims to be able to deliver you a better return than the market itself.

Advertisement
Advertisement

Recommended

Visit/glossary/601570/real-exchange-rate
Glossary

Real exchange rate

The real exchange rate between two currencies combines the nominal exchange rate with the ratio of the price of goods or services in two different cou…
26 Jun 2020
Visit/glossary/esg-investing
Glossary

ESG investing

ESG stands for environmental, social and corporate governance, the areas in which good behaviour is particularly sought.
19 Jun 2020
Visit/glossary/601496/faang-stocks
Glossary

FAANG stocks

The acronym FAANG refers to Facebook, Amazon, Apple, Netflix and Google (Alphabet) – five American companies that have been among the top-performing s…
12 Jun 2020
Visit/glossary/technical-analysis
Glossary

Technical analysis

Technical analysts or 'chartists' attempt to predict future share price (or index) movements by looking at past movements.
5 Jun 2020

Most Popular

Visit/economy/inflation/601584/the-end-of-the-bond-bull-market-and-the-return-of-inflation
Inflation

The end of the bond bull market and the return of inflation

Central bank stimulus, surging post-lockdown demand and the end of the 40-year bond bull market. It all points to inflation, says John Stepek. Here’s …
30 Jun 2020
Visit/investments/commodities/gold/601587/bullish-gold-price-cup-and-handle-chart-pattern
Gold

This chart pattern could be extraordinarily bullish for gold

The mother of all patterns is developing in the gold charts, says Dominic Frisby. And if everything plays out well, gold could hit a price that invest…
1 Jul 2020
Visit/economy/global-economy/601579/how-pent-up-demand-could-drive-a-v-shaped-economic-recovery
Global Economy

How “pent-up demand” could drive a V-shaped economic recovery

“Pent-up demand” is usually a myth. But not this time. The Covid lockdown has created genuine pent-up demand, says Merryn Somerset Webb. That’s now be…
29 Jun 2020