Most stocks are still trading below their 2021 highs. For investors, this means it’s more important than ever to question market-cap-weighted strategies.
To start, it’s important to define market-cap weighting and equal weighting. It ultimately comes down to structuring stock portfolios. Market-cap weighting, the more traditional of the two strategies, assigns a proportionate value to stocks based on their total market capitalization. Companies with higher market values — calculated by multiplying the stock price by the total number of shares outstanding — hold a greater weight in the portfolio. This approach tends to favor large-cap companies. It can also lead to a concentration in a relatively small number of stocks. As a result, portfolio performance often mirrors the performance of the market’s largest constituents.
Equal weighting takes a very different approach by ignoring market-cap hierarchy.
Instead, an equal-weighting strategy assigns an identical weight to every stock within the portfolio, regardless of the company’s size. This strategy democratizes the influence of each stock, ensuring that the performance of smaller companies has an equivalent impact as that of the market giants. Equal weighting encourages a more diversified investment spread, reducing the risk associated with the potential underperformance of large-cap stocks. However, it requires more frequent rebalancing to maintain equal proportions, which can lead to higher transaction costs.
When we look at the price ratio of the Invesco S&P 500 Equal Weight ETF (NYSEARCA:RSP) relative to the SPDR S&P 500 ETF (NYSE:SPY), we see that equal weighting has clearly underperformed market-cap weighting in this cycle.
However, we are now potentially at an inflection point. If breadth widens, more stocks will participate on the upside.
Why do I consider this the most important dynamic of all now?
Because if you’re looking to buy and hold, you don’t need to do so by exposing yourself to the concentration risk of the S&P 500. You can still get exposure to the market with a far more balanced weighting approach. And while the short-term momentum is still favoring market-cap strategies, I think the longer term favors equal-weighting strategies. The question of how you weigh your holdings matters now more than ever.
On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
