Bailout

Why do we invest in cap-weighted indices?

By Felix Salmon

Felix Goltz and Véronique Le Sourd have an interesting paper (PDF) revisiting the question of why so many of us invest in capitalization-weighted stock indices. It turns out that the theory behind our behavior is pretty weak: first of all, you have to believe in the capital asset pricing model, or CAPM. The CAPM includes lots of assumptions which don’t hold in the real world: that all investors have the same risk appetite, for instance; that they all have the same investment horizon; that they can short securities freely; that they pay no taxes or transaction costs; and that all assets can easily be traded, including assets such as human capital and real estate.

If you make all those assumptions, then the CAPM says that the market portfolio is efficient — the market portfolio being, essentially, everything in the world: stocks, bonds, real estate, commodities, human capital, art, social security benefits, automobiles, everything. But the problem, of course, is that cap-weighted indices do a pretty bad job even of reflecting the performance of the stock market as a whole, let alone all global assets. (The world’s assets have grown a lot in the past decade; the S&P 500, not so much.)

The authors conclude:

In view of these arguments, it seems that financial theory alone does not justify the current practice of cap-weighting. In fact, from a theoretical perspective, cap-weighted stock market indices seem to offer no particular advantage.

So why are cap-weighted indices so popular? One reason might be that indices seem to outperform a simple buy-and-hold strategy. And another is that they’re easy to understand and most of them have been around for a long time. Still, it’s worth noting that the most famous stock index in the world, the Dow, isn’t an index at all, and it certainly isn’t cap-weighted. (Although with the Dow, you would have been better off just holding the original 30 stocks than following the vicissitudes of DJIA itself.)

The main reason for buying cap-weighted indices, I think, is that it’s easy and it’s cheap. (That’s probably the main reason not to buy cap-weighted indices, too, since anything easy and cheap is likely to get crowded.) Of all the assets in the world, stocks are the easiest to invest in and the easiest way to invest in stocks is to simply buy the index. I suspect there are many portfolios which do a better job of simply “investing in the world” than the S&P 500 does. But once you take into account the costs of putting them together, it’s probably not worth it.

Full post as published by Macroprudential on July 08, 2010 (boomark / email).