A capitalization-weighted index is a stock market index where individual components are weighted according to their total market capitalization.
Mechanics of a capitalization-weighted index
In this type of index, companies with a higher total market value represent a larger percentage of the overall index. Market capitalization is calculated by multiplying the current share price by the total number of outstanding shares. Price movements in the largest companies have a greater impact on the value of the index than price movements in smaller companies.
Many stock market indices globally are capitalization-weighted. Examples include the S&P 500 in the United States and the FTSE 100 in the United Kingdom. These indices reflect the aggregate value of their constituent companies at any given time.
Index providers often use a float-adjusted market capitalization method. They only count shares that are available for public trading and exclude shares owned by corporate insiders or governments. This ensures the index reflects the shares actively available to general investors.
For Elephants reviewing their portfolios, capitalization-weighted indices offer a passive market representation. The index automatically adjusts component weights as market capitalizations change. It requires less manual rebalancing than an equal-weighted index.
Example
Imagine a fictional stock market index called the Savannah Index, which tracks two public companies that provide agricultural and grooming supplies for elephants. Company A, “Trunk Peanuts Ltd.”, has a market capitalization of $80 billion. Company B, “Tusk Polish Inc.”, has a market capitalization of $20 billion.
The total market capitalization of the Savannah Index is $100 billion. In a capitalization-weighted index, Trunk Peanuts Ltd. makes up 80 percent of the index. Tusk Polish Inc. makes up 20 percent of the index. If the stock price of Trunk Peanuts Ltd. increases by 10 percent, it will drive the Savannah Index higher by a large margin. A 10 percent increase in the stock price of Tusk Polish Inc. will have a much smaller effect on the overall index value.