Comments on: Cap-Weighting Magnifies Your Exposure to Pricing Errors In The Wrong Ways

By: Fundamental Index Returns For 15 Years : WhereDoesAllMyMoneyGo.com

Fundamental Index Returns For 15 Years : WhereDoesAllMyMoneyGo.com — Wed, 14 Jan 2009 03:04:21 +0000

[...] look particularly attractive for fundamental indexation. This might be made more clear by reading this previous post about how cap-weighting magnifies your overpricing errors and reduces your underp… Share and [...]

By: Indexing Based on Fair Values Instead of Market Cap : WhereDoesAllMyMoneyGo.com

Indexing Based on Fair Values Instead of Market Cap : WhereDoesAllMyMoneyGo.com — Wed, 26 Nov 2008 03:42:37 +0000

[...] yesterday’s post, we looked at how our cap-weighted index overweighted the overvalued companies and underweighted the …, thereby magnifying our pricing errors in the exact opposite way that one would desire. Today we [...]

By: Preet

Preet — Wed, 26 Nov 2008 01:45:15 +0000

Hi Sean – “accurately”: you’d never know. There are those who are trying to figure out the next best proxy (I’ll give you a big hint, one of them is fundamental indexing). More to follow on this over time.

By: Sean

Sean — Tue, 25 Nov 2008 20:25:37 +0000

Hey Preet, this is quite an interesting concept, especially since I’m tending to weight the equity portion of my portfolio regionally by market cap. Can you accurately measure/predict the fair value of an entire market or index though (vs. small/mid/large-cap in a single market)? Hopefully I’m making sense here… your example is just blowing my mind at the moment…

By: Preet

Preet — Tue, 25 Nov 2008 13:55:32 +0000

You hit the nail right on the head with your last two lines. I’ll go into weighting based on fair value next (which is impossible to do as you know) and then look at the alternatives.

By: Michael James

Michael James — Tue, 25 Nov 2008 05:14:56 +0000

I like your example to illustrate the effect of weighting errors always working against you. However, it applies to some degree to any kind of weighting system, not just cap-weighting. Any time you try to assess intrinsic value, but get it wrong, you will buy too little of a stock that is better than you think it is and too much of a stock that isn’t as good as you think it is. The important question is whether a given method of assessing intrinsic value is better than approximating intrinsic value with the market cap. This is often easy to do in hindsight, but harder to do looking forward.