GeoffF100 wrote:Nobody knows which or the two shares will do better, or which will prove to be the less risky. When in a hole stop digging. If you do not know more than the market, buy a tracker.
Try a thought experiment. Imagine there are only 2 companies available to invest in, A and B. A is worth 10X B. Both carry the same risk.
Now imagine a pool of investors. Each investor would like to invest an equal amount in A and B because the performance of the companies are not perfectly correlated and their risk is equivalent. However, as you have pointed out, they cannot all do this as that would drive the price of B to a level that would massively overvalue that company, i.e. the expected return would be massively lower than for A.
If, on the other hand, everyone invested according to cap weight then they would all invest 10X as much in A as in B. This is the scenario in which the expected return of A and B would be equivalent. But this is not the ideal investment from the pov of risk as it doesn't benefit fully from the imperfect correlation between the two companies.
In a perfectly efficient market, the solution to this would be a compromise, B should trade at a slight premium to A such that the expected return is slightly lower. I realise this seems counter-intuitive (the smaller company offering a lower expected return) but it makes sense when considering the risk-adjusted return of a portfolio of A and B. It is a natural consequence of diversification benefit. In the real World the opposite is more often the case, smaller companies demand a higher expected return because investors are mostly considering them, and the risk they carry, on an individual basis.
Sadly there is very little evidence available comparing equal weight LTBH strategies with cap weight strategies which means all of this remains primarily theoretical. But if you can obtain even an equivalent expected return from two companies with the same risk then equal weighting has to be the most logical investment strategy.
BoE