Loading the player...

What is a 'Capitalization-Weighted Index'

A capitalization-weighted index is a type of market index with individual components that are weighted according to their total market capitalization. The larger components carry higher percentage weightings, while the smaller components in the index have lower weights. This type of index is also known as a market value-weighted index.

BREAKING DOWN 'Capitalization-Weighted Index'

Most of the broadly used market indexes today are cap-weighted indexes, such as the Standard and Poor's (S&P) 500 Index, the Nasdaq Composite Index, the Wilshire 5000 Total Market Index, the Hang Seng Index and the MSCI EAFE Index. In a cap-weighted index, large price moves in the largest components can have a dramatic effect on the value of the index. Some investors feel that this overweighting toward the larger companies gives a distorted view of the market, but the fact that the largest companies also have the largest shareholder bases makes the case for having the higher relevancy in the index.

Capitalization-Weighted Index Calculation Example

To find the value of a cap-weighted index, an analyst should multiply each constituent's market price by its total outstanding shares to arrive at the total market value. Then, the proportion of this value to the overall total market value of all the index components gives the weight of the company in the index. For example, consider the following five companies:

Company A: 1 million shares outstanding, current price per share equals $45

Company B: 300,000 shares outstanding, current price per share equals $125

Company C: 500,000 shares outstanding, current price per share equals $60

Company D: 1.5 million shares outstanding, current price per share equals $75

Company E: 1.5 million shares outstanding, current price per share equals $5

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

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

This means that the entire market value of all the index components equals $232.5 million, giving Company A a weight of 19.4%, Company B a weight of 16.1%, Company C a weight of 12.9%, Company D a weight of 48.4% and Company E a weight of 3.2%. Even though the final two companies have equal amounts of shares outstanding, they are actually the highest and lowest weighted companies in the index because of the effects of their prices on their individual market values.

In practice, an index divisor is calculated to make reporting of the index level easier and more manageable. In this example, on day one of the index, a likely index divisor would be $232,500. This would give the index an initial value of $232,500,000 / $232,500 = 1,000.

Downside of Capitalization-Weighted Indexes

Certain companies can grow to the point that they take up an inordinate amount of space in an index. As a company grows, index designers are obligated to appoint a greater percentage of the company to the index. This can endanger a diversified index by placing too much weight on one individual stock's performance. In addition, index funds buy more of the stock as its market capitalization increases, meaning its share price has gone up. This goes against the traditional investing mantra of buying at low rather than high prices.

Moreover, as index funds proliferate, their collective purchasing decisions can have a dramatic affect on a stock's price, as they buy more the more a stock goes up. This can lead to stock market bubbles and, subsequently, bursts. 

RELATED TERMS
  1. Weighted Average Market Capitalization

    Weighted average market capitalization refers to a type of stock ...
  2. Composite

    A composite is a grouping of equities, indexes or other factors ...
  3. Indexing

    In the financial markets, indexing can be used as a statistical ...
  4. Price-Weighted Index

    A stock index in which each stock influences the index in proportion ...
  5. Dow Jones Global Titans 50 Index

    A market capitalization-weighted index of 50 of the largest multinational ...
  6. Nasdaq Composite Index

    A market-capitalization weighted index of the more than 3,00 ...
Related Articles
  1. Investing

    3 Types Of Indexing For ETF Success

    ETF success relies on the index with which it's paired. Discover three index genres for tracking average market performance.
  2. Investing

    S&P 500 ETFs: Market Weight Vs. Equal Weight (RSP, SPY)

    Both S&P 500 and S&P 500 EWI indexes include the same set of stocks, but different weighting strategies give them separate individual properties.
  3. Investing

    The Pros and Cons of Indexes

    Learn about the advantages and disadvantages of stock indexes and passive index funds. Discover how there is an opportunity cost to using index funds.
  4. Investing

    Introduction To Fundamentally Weighted Index Investing

    If you believe the market smiles on those who focus on value, growth or income, this vehicle may be for you.
  5. Investing

    The Hidden Flaws of Index Investing

    Index investing isn't always better than active investing. Here's why.
  6. Investing

    Investigating the Effectiveness of Equal-Weight ETFs

    Investors should know the ins and outs of equally weighting stocks before considering the related ETFs.
  7. Investing

    ETF Tracking Errors: Protect Your Returns

    Tracking errors tend to be small, but they can still adversely affect your returns. Learn how to protect against them.
  8. Investing

    The Benefits of Fundamental Indexing

    Fundamental Indexing shuns outside price influence and prefers to value its components using intrinsic factors, making it a more mindful way to invest.
  9. Financial Advisor

    The 4 Best U.S. Equity Index Mutual Funds

    Find out which four index mutual funds are among the best U.S. equities index mutual funds for core holdings in your investment portfolio.
  10. Insights

    An Introduction to Stock Market Indices

    Lear more about the five most talked about stock indices and what makes them all different.
RELATED FAQS
  1. What is a capitalization-weighted index?

    Learn about a capitalization-weighted index and how to calculate the value of a capitalization-weighted index through a simple ... Read Answer >>
  2. Is it possible to invest in an index?

    While you cannot buy indexes, which are just benchmarks, there are three ways for you to mirror their performance. Read Answer >>
  3. What are the pros and cons of using the S&P 500 as a benchmark?

    Learn about the advantages and disadvantages of using the S&P 500 as a benchmark for portfolio performance, and understand ... Read Answer >>
  4. Weighted Average Shares Vs. Outstanding Shares

    What's the difference between weighted average shares outstanding and basic weighted average shares? Read Answer >>
  5. How Do I Find Mutual Funds That Track Indexes?

    Two good sources for finding index funds are Fidelity Investments and Vanguard. Read Answer >>
Hot Definitions
  1. Ethereum

    Ethereum is a decentralized software platform that enables SmartContracts and Distributed Applications (ĐApps) to be built ...
  2. Cryptocurrency

    A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
  3. Financial Industry Regulatory Authority - FINRA

    A regulatory body created after the merger of the National Association of Securities Dealers and the New York Stock Exchange's ...
  4. Initial Public Offering - IPO

    The first sale of stock by a private company to the public. IPOs are often issued by companies seeking the capital to expand ...
  5. Cost of Goods Sold - COGS

    Cost of goods sold (COGS) is the direct costs attributable to the production of the goods sold in a company.
  6. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and expenses incurred during a specified period of time, usually ...
Trading Center