Market value weighted equity indices. Now, a market value weighted may be called by a handful of different names. You might see market cap weighted, or market capitalization weighted, or cap weighted, or even value weighted. Now, a market value weighting for indices is by far the most common methodology, and it's based on the size of each individual firm. So, in a market cap weighting, the weight of each constituent company or security is determined by dividing its market cap, or its value, by the total value of all securities in the index. So in the end, the largest companies by value, have the biggest influence on the value of the overall index and the overall change in the index. A couple of the most common examples, but there are many, many more, obviously, since it is the most commonly used methodology, the S&P 500 index, the Nasdaq, and the FTSE all used a market value weighted methodology. Now, the advantage of using a market value weighted methodology is somewhat obvious, right? It reflects the way markets actually behave. Larger companies, do in fact have more influence and effects on the overall market and the economy than smaller companies, so it's beneficial to give them a larger weight in an index. And another added benefit is that market value weighted indices are self-rebalancing in a sense, which means that as a company's price and value changes, so does the proportion of that company in the index basket. Now, the primary disadvantage of a market value weighted index is that it can be momentum driven. What does that mean? Well, underlying securities whose prices have risen the most, have a greater weight on the index, and vice versa. Companies that have fallen the most, have a lower weight in the index. Now, this could lead to overweighting stocks that have risen in price and may be overvalued, or underweighting stocks that have declined in price, but in actuality, they may be undervalued. In the end, the fact is similar to a momentum investment strategy, which essentially bets that near-term price movement will continue in the future.
