No. of Recommendations: 7
But isn't this a factor IN FAVOR of cap weighting as opposed to equal weighting? If you cap weight, as the companies go out of favor, and as their market cap drops, the percentage they comprise of the index also drops. Meanwhile, when they are equal weight, the percentage they comprise in the index remains the same until the bitter end (when they fade to nothingness). Let's say a company is worth $5T and is 7.12% of the S&P500 index. And let's say that company has issues and next year is only $3.5T, then it'll go down to about 3% of the index. And let's say the company continues to have problems and drops in value to $1T? Then it'll drop to only 1.5% of the index. Meanwhile if it were equal weight, it would be 0.2% of the index at $5T, and 0.2% of the index at $3.5T, and 0.2% of the index at $1T. And if it heads to failure and nears the zero value, it'll still be 0.2% of the equal weight index as it becomes a zero (or gets removed from the index altogether).
I agree with Jim's response, but here's another way of looking at it.
Some companies will go up, and others will go down, and both the market-cap weighted SPY and the equal weight RSP will have the same numbers of winners and losers. But the thing about the SPY is that the top firms are very heavily weighted - right now, the top 20 firms are worth about as much as the other 480 firms combined. So the whole question becomes, do those top 20 firms tend to have good returns, or not? If the answer is no, as much research indicates, then you don't want to be overweight those top 20 firms. This only seems counterintuitive because the top 20 firms have done so spectacularly well, in the last few years, which obviously is why they are the top 20! But looking at the top 20 from, say, 30, 25, 20, 15, 10 and 5 years ago, to see if they were good investments, provides some perspective.
The fact that firms like GE, AIG, Fannie Mae, Merck, Pfizer, Procter and Gamble, Johnson and Johnson, Cisco, Intel, etc. were for a short period of time heavily in favour, and have done terribly since then, means a SPY strategy would have had you heavily overweight in all these poorly performing stocks. The most you could lose with RSP when a firm goes bankrupt is 0.2%, but you actually lose a lot more if your Chevron goes from 1.6% in 2010 to 0.95% in 2015, for instance, just because oil stocks were doing really well in 2010.
To be fair, if you look at what you would have owned in, say, 2015, and how that has done since then, you would have done quite well being overweight the giants (Apple, Alphabet, Microsoft, Berkshire, Exxon, Amazon, Meta, etc.), as it turns out that most of those companies have done very well, changing their acronyms over the years (FANG, FAANG, MAMAA, Mag 7), staying near the top. And obviously that is why the SPY has outperformed the RSP recently. But if you go a bit farther back, it is easy to see why the stocks at the top of the list include a lot that are only temporarily in favour, and lose big percentages when they fall out of favour.
dtb
