In his book The Big Secret for the Small Investor, Joel Greenblatt explains how market-cap-weighting guarantees an imbalanced portfolio, favoring overpriced stocks and neglecting bargain-priced ones, regardless of whether one can identify specific mispriced stocks or not. Here’s an excerpt from the book:
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 market-cap-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.
You can find the book here:
Joel Greenblatt – The Big Secret for the Small Investor
For all the latest news and podcasts, join our free newsletter here.
Don’t forget to check out our FREE Large Cap 1000 – Stock Screener, here at The Acquirer’s Multiple:
