QE and index funds have deformed the stock market as predicted by Goodhart’s Law.

[tjh290633]

. Holding 1000 stocks and assuming equal initial weighting you have just 0.1% invested in the best performing holding. Hold 10 stocks and you have 10% in the best. For the former the best is inclined to be a 10 times better/greater gain than the best of the set of 10, but where overall the portfolio rewards/outcome are broadly the same.

.

Equal weighting assumes that the returns from, say, a betting company will be the same as from an international energy company. That just doesn't happen in practice. Portfoilio construction is not like stamp collecting where you want one of each.

The real point is that, for a private investor, equal weighting is a practicable method. For the institutional investor it is virtually impossible. You set limits on the divergence from equal weighting, both top and bottom, and take corrective action when those limits are breached, taking safeguards not to deviate from your guiding principles.

TJH

[OhNoNotimAgain]

My unproven gut feeling over the years is that frequently the companies with the largest capitalisations are in the latest-fad sector of the market and sit on relatively high valuations.
High valuations usually mean-revert downwards causing underperformance as markets rotate into another sector when the fad changes.

Therefore I suspect that more often than not, cap-weighting tends to underperform equal-weighting and cap-weighting concentrates risk while equal-weighting spreads risk.

In the US that may be the case where fads and caap weighted trackers are more powerful.

But that is not the case in the UK

[OhNoNotimAgain]

The real point is that, for a private investor, equal weighting is a practicable method. For the institutional investor it is virtually impossible. You set limits on the divergence from equal weighting, both top and bottom, and take corrective action when those limits are breached, taking safeguards not to deviate from your guiding principles.

TJH

Just because it is practical does not make it sensible.

Do you equal weight your spending?

[tjh290633]

The real point is that, for a private investor, equal weighting is a practicable method. For the institutional investor it is virtually impossible. You set limits on the divergence from equal weighting, both top and bottom, and take corrective action when those limits are breached, taking safeguards not to deviate from your guiding principles.

TJH

Just because it is practical does not make it sensible.

Do you equal weight your spending?

That is not the same subject. With wide variation in the values of capitalisation of shares in the main index, it would be necessary to have holdings of a few pence were an individual to use market weighting.

Presumably you have an alternative method to promote?

TJH

[OhNoNotimAgain]

That is not the same subject. With wide variation in the values of capitalisation of shares in the main index, it would be necessary to have holdings of a few pence were an individual to use market weighting.

Terry, you know the maths of weighted averages better than the next man. The bulk of the market return comes from a couple of dozen stocks. Get those right, with appropriate weightings and you are sorted. There is simply no need to dredge around in the mud for a few tiddlers in the hope of making a killing because unless you massively overweight them, and increase your risk, they won't make a difference.

[GoSeigen]

That is not the same subject. With wide variation in the values of capitalisation of shares in the main index, it would be necessary to have holdings of a few pence were an individual to use market weighting.

Terry, you know the maths of weighted averages better than the next man. The bulk of the market return comes from a couple of dozen stocks. Get those right, with appropriate weightings and you are sorted. There is simply no need to dredge around in the mud for a few tiddlers in the hope of making a killing because unless you massively overweight them, and increase your risk, they won't make a difference.

This looks like a straightforward making money slowly vs making money fast argument. Tiddlers produce little of the market return but have the potential to produce those returns extremely rapidly, while the monsters produce the bulk of the return but at a relatively boring, plodding rate.

GS

[1nvest]

The real point is that, for a private investor, equal weighting is a practicable method. For the institutional investor it is virtually impossible. You set limits on the divergence from equal weighting, both top and bottom, and take corrective action when those limits are breached, taking safeguards not to deviate from your guiding principles.

TJH

Just because it is practical does not make it sensible.

Do you equal weight your spending?

That is not the same subject. With wide variation in the values of capitalisation of shares in the main index, it would be necessary to have holdings of a few pence were an individual to use market weighting.

Presumably you have an alternative method to promote?

TJH

Pyad's HYP, buy and hold, tends to see weightings drift to holding substantial exposure in a relatively small number of holdings, might be considered as drifting towards cap weighting. Terry's HYP is more towards persistent equal weighting. Both have/tend to see similar overall rewards, but where equal weighted has less single stock concentration risk, so might be considered as being safer, a better risk-adjusted reward. Sooner or later concentration risk can backfire, resulting in worse overall outcome. To some extent that has been seen in the FT100 stock index, overweighted financials for instance across the 2008/9 financial crisis ..etc. The FT100 has at times seen single stocks breaching the 10% per single stock rule cap. In contrast for the US S&P500 I believe no single stock has ever been more than 5%. Japan 1990 is another example, relatively few stocks grew to become giants, Sony, Yamaha ...etc. and when they faltered, even after they'd halved and more, they still dominated the Index such that investors in the broad index saw poor returns for the next decade+

Concentration risk is a major risk, but is one that is easily diversified away (diluted). On the cost front however and rebalancing is more expensive than not, however those costs can be relatively small, to levels of near insignificance, subject to how/how-often you manage rebalancing.

[OhNoNotimAgain]

Pyad's HYP, buy and hold, tends to see weightings drift to holding substantial exposure in a relatively small number of holdings, might be considered as drifting towards cap weighting. Terry's HYP is more towards persistent equal weighting. Both have/tend to see similar overall rewards, but where equal weighted has less single stock concentration risk, so might be considered as being safer, a better risk-adjusted reward. Sooner or later concentration risk can backfire, resulting in worse overall outcome. To some extent that has been seen in the FT100 stock index, overweighted financials for instance across the 2008/9 financial crisis ..etc. The FT100 has at times seen single stocks breaching the 10% per single stock rule cap. In contrast for the US S&P500 I believe no single stock has ever been more than 5%. Japan 1990 is another example, relatively few stocks grew to become giants, Sony, Yamaha ...etc. and when they faltered, even after they'd halved and more, they still dominated the Index such that investors in the broad index saw poor returns for the next decade+

Concentration risk is a major risk, but is one that is easily diversified away (diluted). On the cost front however and rebalancing is more expensive than not, however those costs can be relatively small, to levels of near insignificance, subject to how/how-often you manage rebalancing.

NSS!

All portfolios, if left, tend to become scruffily cap weighted.

[tjh290633]

All portfolios, if left, tend to become scruffily cap weighted.

That is a good reason for rebalancing to some extent. HYP1 is the classic example of benign neglect.

TJH

[AWOL]

The real point is that, for a private investor, equal weighting is a practicable method. For the institutional investor it is virtually impossible. You set limits on the divergence from equal weighting, both top and bottom, and take corrective action when those limits are breached, taking safeguards not to deviate from your guiding principles.

TJH

Just because it is practical does not make it sensible.

Do you equal weight your spending?

That is not the same subject. With wide variation in the values of capitalisation of shares in the main index, it would be necessary to have holdings of a few pence were an individual to use market weighting.

Presumably you have an alternative method to promote?

TJH

Seeing as we are in the passive forum.... Cap weighting can be very cheap if an index fund is purchased. There are also equal weighed ETFs. They have not outperformed however under some market conditions they may do. Perhaps if value does well for an extended period.

[OhNoNotimAgain]

Seeing as we are in the passive forum.... Cap weighting can be very cheap if an index fund is purchased. There are also equal weighed ETFs. They have not outperformed however under some market conditions they may do. Perhaps if value does well for an extended period.

EW just brings in a small cap bias.

[tjh290633]

Seeing as we are in the passive forum.... Cap weighting can be very cheap if an index fund is purchased. There are also equal weighed ETFs. They have not outperformed however under some market conditions they may do. Perhaps if value does well for an extended period.

EW just brings in a small cap bias.

And it removes a large cap bias.

TJH

[Bubblesofearth]

Terry, you know the maths of weighted averages better than the next man. The bulk of the market return comes from a couple of dozen stocks. Get those right, with appropriate weightings and you are sorted.

Totally agree. I've looked back over a few time periods and, after a careful review of share performance tables, have managed to do exactly what you say.

All I need to do now is the same but without the performance tables, i.e. for a portfolio launched today rather than a decade ago.

BoE

[1nvest]

Terry, you know the maths of weighted averages better than the next man. The bulk of the market return comes from a couple of dozen stocks. Get those right, with appropriate weightings and you are sorted.

Totally agree. I've looked back over a few time periods and, after a careful review of share performance tables, have managed to do exactly what you say.

All I need to do now is the same but without the performance tables, i.e. for a portfolio launched today rather than a decade ago.

BoE

The appropriate weightings is to initially equal weight holdings, unless you opine you can pick those that will be the best/right-tail holdings in advance (as simple as that may seem, more likely you can't as the best forward time cases more often are surprising). After that it doesn't matter if you do or don't rebalance, other than non-rebalanced tending towards having more concentration risk in having found its own cap weighting and where you likely end up at a point where a initial portfolio of say 20 stocks initially weighted 5% each having become 80% of the portfolio value held in a handful of the stocks (the best performing stocks/sectors across that period of time). Look at rebalancing as a possible case of selling/reducing out of your best performers to add to laggards that may continue to lag.

Buying initially into the ongoing market cap weighting is weighting more initially into what sectors/stocks had already been the historic best/right-tail sectors/stocks, where there is no guarantee that that momentum will be sustained into the future. Leaving less weighting having been bought of alternative sectors/stocks that may very well be the best/right-tail in forward time.

When I last looked at HYP1 (non rebalanced initial equal weighted), compared to TJH HYP (rebalanced/equal weighted) 2000 to 2020 inclusive, total returns (accumulation) the linest(ln ... (slope of exponential trend line) values were more or less the same, as were the motions of the total return lines. The standard deviation in yearly total returns was higher for TJH-HYP than for HYP1, so for those particular cases the risk/reward was better for HYP than for TJH-HYP (same/similar gain with less volatility (where volatility is considered as being a 'risk')).

Another real world example is US LEXCX that started with 30 shares in the 1930's, bought and held (no rebalancing), that broadly has compared to the market index (rebalanced).

You can do OK/well either way, rebalance or not, however a set of 20 or 30 stocks sampling based approach will have some pick above average holdings, other pick below average holdings, deviations in individual cases around the mean. Buying into the entire set of stocks has you achieve the central mean/average. Broadly, on average, sampling is considered as taking on additional uncompensated (on average) risk.

[OhNoNotimAgain]

And it removes a large cap bias.

TJH

Why is that bad?

[tjh290633]

And it removes a large cap bias.

TJH

Why is that bad?

Have a look at the dot-com mania around the turn of the century, if you want an example.

TJH

[OhNoNotimAgain]

And it removes a large cap bias.

TJH

Why is that bad?

Have a look at the dot-com mania around the turn of the century, if you want an example.

TJH

Which is the point of the OP. Weighting by mkt cap is what created that problem, and has subsequently continued and got worse.

Big companies are not bad because they are big. Large, profitable companies are perfectly fine. Huge companies with extortionate valuations and little or no profits or cash flow is where the problem.

Weighting by price does not discriminate between the two and leads to misallocation of capital.

[GeoffF100]

And it removes a large cap bias.

TJH

Why is that bad?

Have a look at the dot-com mania around the turn of the century, if you want an example.

TJH

Which is the point of the OP. Weighting by mkt cap is what created that problem, and has subsequently continued and got worse.

Big companies are not bad because they are big. Large, profitable companies are perfectly fine. Huge companies with extortionate valuations and little or no profits or cash flow is where the problem.

Weighting by price does not discriminate between the two and leads to misallocation of capital.

No it does not. It does not change the allocation of capital at all. The market does overvalue some companies, both big and small. You can bet against those companies by under-weighting them or short selling them. The problem is that the professionals do not have any better than luck chance of success at that. Nonetheless, wishful thinking springs eternal. There are plenty who believe that they are better than the professionals. There are also plenty who believe (against all evidence) that they can predict which professionals will beat the market. There are also countless professionals who are out to exploit that wishful thinking.

[OhNoNotimAgain]

[quote="GeoffF100"
No it does not. It does not change the allocation of capital at all. The market does overvalue some companies, both big and small. .[/quote]

But it does impact the allocation of new money. Inflows in a cap weighted index fund are allocated according to price. More money goes into expensive stocks than cheap stocks.

[GeoffF100]

No it does not. It does not change the allocation of capital at all. The market does overvalue some companies, both big and small...

But it does impact the allocation of new money. Inflows in a cap weighted index fund are allocated according to price. More money goes into expensive stocks than cheap stocks.

Yes, but that is the correct allocation of new money, according to the market. If the same amount of money was allocated to each stock irrespective of size, the small stocks would become horrendously overpriced. The same price for buying out Apple and a small market stall would not make any sense.