Market Beat: The market capitalization of index funds
November 19, 2018
Broad-based low-cost index funds are a staple part of most investors' portfolios. They give investors exposure to an entire stock index with low expenses ratios.
Younger people that are starting their first retirement accounts at work should consider dollar cost averaging into a low-cost stock index fund for a long period of time to build their retirement savings.
The first index funds were created by John Bogle at Vanguard who worked closely with Burton Malkiel, the author of "A Random Walk Down Wall Street." Their theory was to invest in the overall market, keep the costs low and don't try to beat the market.
Index funds have grown enormously in popularity since the first one was created in 1976. Exchange traded funds or ETFs were first started in the 1990s and the first ones were also based on stock indexes. The initial ETFs were the Diamond and the Spyder, the Diamond is based on the Dow Jones Industrial Average and the Spyder is an S&P 500 index fund.
Most index funds are weighted by market cap. Market cap means market capitalization and is calculated by multiplying the share price of the stock by the number of shares outstanding. So, if you purchase an S&P 500 index fund, you'll have exposure to the 500 largest companies in the United States, but you won't have an even amount in each stock. Since the funds use market cap for the weighting, you'll have more money invested in the largest stocks than the smaller ones.
The largest companies in the U.S. right now include companies like Apple, Amazon, Alphabet, Facebook, Johnson & Johnson and Microsoft. With an index fund investment, you'll have more exposure to the mega cap stocks and technology stocks in general.
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An alternative is to use what's referred to as an equal weighted fund. With an equal weighted index fund, your money will be spread out evenly across all the stocks that make up the index, giving the investor more exposure to the companies in the index with a smaller market cap.
Diversification is one of the best tools investors can use to manage risk. The old saying, "don't put all your eggs in one basket" makes sense. If you drop the basket, all the eggs could break. By spreading risk, you can lower it.
Equal weighted funds can be a good way to help diversify a little more.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.