In Joel Greenblatt’s book – The Big Secret, he discusses how market-cap-weighted index funds guarantee investors own less bargain priced stocks. Here’s an excerpt from the book:

Buffett considers Graham’s contributions with regard to the idea of investing with a large margin of safety and the metaphor of viewing stock price fluctuations in the context of Mr. Market as the two most important concepts in investing.

So what does this have to do with index funds? Well, a lot, actually. Here’s why. If Graham and Buffett are right, over the short term at least, stock prices can sometimes reflect emotions rather than value.

In other words, there are times when people get excited by the prospects for a particular company or industry group and overpay for these stocks. At the same time, there are often other companies or industries where investors get unduly pessimistic. These stocks can get oversold and trade at prices much lower than fair value. How does a market-cap-weighted index such as the S&P 500 or Russell 1000 deal with these situations?

Not well. Remember, a market-cap-weighted index ends up having a larger weighting in stocks that increase in value and a smaller weighting in companies whose prices decrease. As Mr. Market gets overly excited about certain companies and overpays, their weighting in a market-cap-weighted index rises.

Consequently, an index fund that owns these same stocks ends up being more heavily weighted in these overpriced stocks. If Mr. Market is overly pessimistic about particular companies or industries, the opposite happens. The stock prices of these companies fall below fair value, and the index and the accompanying index fund effectively own less of these bargain-priced stocks.

In fact, the effect of owning too much of the overpriced stocks and too little of the bargain-priced stocks is actually built into the marketcap-weighting system. Again, as stocks move up in price, we own more of them through the index. As stocks move down in price, we own less of them.

So as Internet stocks moved up in price and market capitalization in the late 1990s, the major indexes became more heavily weighted in this overpriced sector. The more expensive and overpriced they got, the more the index owned. This is the exact opposite of what an investor should want.

On the other hand, many companies in traditional industries with solid earnings and good prospects were ignored by the market. Many of these companies were priced well below fair value. Unfortunately, the market-cap-weighted index effectively owned too little of these bargain companies—their low market capitalizations resulted in index weightings that were much too low.

In effect, if emotions really do drive certain stocks to be overpriced and others to be underpriced, a market cap weighting guarantees that we will own an inferior portfolio. We don’t even have to identify which stocks are overpriced and which are underpriced. As long as we know that at least some stocks are mispriced relative to their fair value, weighting by market cap will ensure that we buy too much of the overpriced ones and too little of the bargains.

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