Capitalization-Weighted Index: Definition, Calculation, Example

A capitalization-weighted or market value-weighted index has individual components whose influence is based on their market capitalization (market cap). A stock market index measures a subset of the stock market. These stocks represent a particular market or a segment of it, helping investors compare current and earlier prices to gauge that market's performance. The most well-known stock market indexes include the S&P 500 and the Nasdaq composite, both of which use the cap-weighted method.

Key Takeaways

Capitalization weighting is a method for constructing an index according to the relative total market value of the stocks it's covering.
The components with higher market caps carry greater weight in the index. Conversely, those with smaller market caps have a lower weight in the index.
Critics of cap-weighted indexes argue that overweighting larger companies gives a distorted view of the market.

With the capitalization-weighted method, the index components with a higher market cap will have a greater impact on the index. Proportionally, the performance of companies with a small market cap will have less of an influence on the index's performance. Other methods for computing the value of stock market indexes include weighting by price, by fundamentals, and by giving each stock equal importance.

Understanding Capitalization-Weighted Indexes

Market capitalization is derived by multiplying the number of outstanding shares by the market price for each share. This is one of several ways to determine a company's size, including sales or total asset figures.

For a capitalization-weighted index, significant changes in the share price of its largest companies significantly influence the value of the overall index. However, since large companies with many outstanding shares tend to be more stable revenue producers, they also produce steady growth for the index. Meanwhile, small companies tend to have a lower weighting, which can reduce risk if the companies don't perform well.

Market-cap indexes provide investors with information on a wide variety of large and small companies. Many stock market indexes are capitalization-weighted indexes, including the S&P 500, the Wilshire 5000 Total Market, and the Nasdaq composite indexes.

Critics of the capitalization-weighted indexes argue that giving such weight to the most prominent companies presents a distorted view of the market. However, the largest companies also have the largest shareholder base, which makes a case for having a higher weighting in the index.

A company's market capitalization is calculated by multiplying its number of outstanding shares by the current price of a single share. In this way, market capitalization reflects the total market value of a firm's outstanding shares.

Calculation of a Capitalization-Weighted Index

To find the value of a capitalization-weighted index, multiply each component's market price by its total outstanding shares to arrive at the total market value. The proportion of the stock's value to the total market value of the index components is the company's weight in the index. Here are examples of 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

Here is the total market cap for each based on the above:

Company A market value = (1,000,000 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 entire market value of the index components would equal $232.5 million given the following weights 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)

Although companies D and E have equal amounts of shares outstanding—1,500,000—they represent the highest and lowest weightings in the index, respectively, because of the effect of their prices on their market value.

Advantages and Disadvantages of Capitalization-Weighted Indexes

Pros

Capitalization-weighted indexes reflect the market’s collective opinion of each stock’s relative value.
Large well-established companies have a greater weighting, providing lower volatility to the index and investors.
Funds that track cap-weighted indexes cut back on turnover and the related trading costs.

Cons

As a stock price rises, a company can gain excessive weight in an index.
Companies with larger weightings can have a disproportionate influence on the fund's performance.
Fund managers often add shares of overvalued stocks, which then raises its weighting, potentially creating a bubble.

Many of the most popular benchmark indexes are market cap-weighted, making them easily accessible to most investors looking to access a well-diversified, broad-based portfolio. Over time, however, if certain companies grow enough, they can take up excessive weight in an index. As a company grows, index designers must appoint a more significant percentage of the company to the index. These companies tend to be less volatile, more mature, and better suited for most investors as core holdings. At the same time, this effect can endanger a diversified index by placing too much weight on one individual stock's performance.

In addition, since they base their composition on these indexes, index funds and exchange-traded funds (ETFs) are often compelled to buy additional shares of a stock as its market capitalization increases or as the share price increases. This process occurs automatically as these funds are programmed to match the index's current composition. Therefore, as a stock's price rises and its relative weight in the index grows, these funds buy more shares at higher prices.

This strategy might seem at odds with the traditional investment wisdom of "buying low and selling high." In typical individual investing, the goal is to buy stocks with low prices and sell them when the prices rise to make a profit. However, index funds and ETFs run on a different principle. Their aim is not to time the market for individual gains but to give a return that mirrors the overall performance of a market index.

If a company's stock were fundamentally overvalued (i.e., from a technical analysis standpoint), buying the stock as its price and market cap increase could create an artificial bubble in the stock price. As a result, buying stocks based on market-cap weightings can lead to overbought conditions. If the bubble were to burst, this would send stock prices lower.

The Dow Jones Industrial Average (DJIA) is perhaps the most significant index not capitalization-weighted. Instead, it reflects the sum of the price of one share of stock for all the components, divided by a proprietary Dow Divisor. Thus, a one-point move in any component stock will move the index by the same number of points.

Example of a Capitalization-Weighted Index

The S&P 500 is a capitalization-weighted index that contains some of the most well-established companies in the U.S. Here is a historical real example of how the index performed on a particular trading day, March 22, 2019:

Boeing (BA) closed down -2.83% to $362.17 while Microsoft (MSFT) closed down -2.64% to $117.05 for the day.
Boeing had a market cap of $205.39 billion and a weighting of less than 1% in the S&P that day.
Microsoft had a market cap of $902.61 billion and a weighting of over 3% in the S&P.
As a result, Boeing's price decline had a more minor effect on the S&P than Microsoft's, even though both stocks declined by almost the same percentage.
As such, Microsoft caused a more significant decline in the S&P than Boeing because it 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 prices, which results in varying impacts on an index's overall value.

What Is an Equal-Weighted Index?

All components in an equal-weighted index are given the same influence, regardless of their market size. This means that each stock in the index contributes the same to its performance. The advantage of this approach is that it gives more prominence to smaller companies, potentially offering a more balanced view of the market than cap-weighted indexes. However, it requires frequent rebalancing to maintain equal weighting, which can lead to higher transaction costs.

What Other Methods Are Used to Construct Indexes?

Besides the capitalization-weighted and equal-weighting approaches, there are several methods used to construct indexes:

Price-weighted indexes: In a price-weighted index, the higher a company's stock price, the more it contributes to the index. The DJIA is a prominent example of a price-weighted index. This method can be misleading, as a high stock price does not necessarily correlate with the company's size or health.
Fundamentally weighted indexes: These are based on financial metrics such as earnings, dividends, sales, or book value rather than market capitalization. It focuses on a company's economic footprint rather than its stock market value. This method aims to avoid some market distortions found in cap-weighted indexes and potentially offer better long-term returns.
Factor Indexes: Factor indexes are constructed according to attributes believed to drive market returns, such as value, size, momentum, quality, and volatility. For example, a low-volatility index would emphasize stocks with historically lower price fluctuations.

What Are Some Important Market-Cap Weighted Indexes?

Some of the most prominent capitalization-weighted indexes include the S&P 500, which tracks the performance of 500 large-cap U.S. stocks, and the Nasdaq composite, which focuses on the largest companies on the tech-heavy Nasdaq stock exchange. These indexes are widely followed and considered benchmarks for the overall health of the U.S. stock market.

The Bottom Line

A capitalization-weighted index gives more weight to companies with higher market caps, meaning these larger companies have a more significant influence on the index's performance. While this provides a reflection of the market's collective opinion and can offer lower volatility, it also means that large companies can disproportionately influence the index. This approach contrasts with other methods like equal-weighted, price-weighted, and fundamentally weighted indexes, each with its own set of advantages and limitations.