Capitalization-Weighted Index

What Is a Capitalization-Weighted Index?

A capitalization-weighted index is a type of stock market index where individual components of the index are included in amounts that correspond to their total market capitalization (shortened as "market cap"). A company's market capitalization is calculated by multiplying its outstanding shares by the current price of a single share. (Outstanding shares are those owned by individual shareholders, institutional block holdings, and company insider holdings.) In this way, market capitalization reflects the total market value of a firm's outstanding shares. A capitalization-weighted index is also known as a market value-weighted index

A stock market index measures a subset of the stock market and helps investors compare current price levels with past prices in order to glean information about the current market performance. The three major U.S. stock indexes are the Nasdaq Composite Index (IXIC), the Dow Jones Industrial Average, and Standard and Poor's (S&P) 500 Index. An index is computed using various methods (including the capitalization-weighted method) with the prices of selected stocks.

With the capitalization-weighted method, the index components with a higher market cap will receive a higher weighting in the index. Proportionally, the performance of companies with a small market cap will have less of an impact on the performance of the overall index. Other methods for computing the value of stock market indexes are the price-weighted, fundamental-weighted, and equal-weighted index construction methods.

Understanding Capitalization-Weighted Indices

Many stock market indexes are capitalization-weighted indexes, including the S&P 500 Index, the Wilshire 5000 Total Market Index (TMWX), and the Nasdaq Composite Index (IXIC). Market-cap indexes provide investors with information about a wide variety of companies — both large and small.

A capitalization-weighted index uses a company's market capitalization to determine how much impact that particular security can have on the overall index results. Market capitalization is derived from the value of outstanding shares. The investment community can use market capitalization to determine a company's size, as opposed to using sales or total asset figures.

In the composition of a capitalization-weighted index, large movements in the price of shares for the largest index companies can significantly impact the value of the overall index. However, since large companies with numerous outstanding shares tend to be more stable revenue producers, they can also provide steady growth for the index. On the other hand, small companies tend to have a lower weighting, which can reduce risk if the companies don't perform well. 

Critics of the capitalization-weighted indexes might argue that the overweighting of the largest companies can give a distorted view of the market. However, the largest companies also have the largest shareholder bases, which makes a case for having a higher weighting in the index.

Calculation of a Capitalization-Weighted Index

To find the value of a capitalization-weighted index, first 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 overall total market value of the index components provides the weighting of the company in the index. For example, consider the following five companies:

The total market value of each company would be calculated as:

The entire market value of the index components equals $232.5 million with the following weightings for each company:

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 effects of their prices on their individual market values.

Advantages and Disadvantages of Capitalization-Weighted Indexes

Many of the world's most popular benchmark indexes are market cap-weighted, making them easily accessible to most investors to gain access to a well-diversified, broad-based portfolio. Over time, however, if certain companies grow enough, they can end up making up an excessive amount of the weighting in an index. This is because, as a company grows, index designers are obligated to appoint a greater 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 as it comes to dominate the index make-up.

In addition, index funds and exchange-traded funds buy additional shares of a stock as its market capitalization increases or as the share price increases. In other words, as the stock price is rising, these funds purchase more shares at the higher prices; this can be counterintuitive to the investing mantra of buying low and selling high.

If a company's stock is fundamentally overvalued (from a technical analysis standpoint), the purchasing of the stock as its price (and thus, its market cap) increases can create a bubble in the stock's price. As a result, purchasing stocks based on market-cap weightings can lead to a stock market bubble. If the bubble were to burst, this would send stock prices into a free fall.

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. The following is a historical real example of how the index functioned on a particular trading day:

It's important to note that the weightings of the S&P 500 change daily with the companies' outstanding shares and their prices, which results in varying impacts on the Index's overall value.