Home » Blog » It really matters how much weight each component carries

It really matters how much weight each component carries

It is important not only what we invest in, but also the proportion in which we hold each asset. The same Dow Jones Industrial Average basket of thirty stocks has a completely different risk-return profile if we weight them differently. Let’s see what this means in practice with three different versions.

 

Common index weighting methods

In market cap weighted indices, the weight of companies is proportional to their total stock market value, i.e., the product of their share price and number of shares. This is how the S&P 500, which tracks the average share price change of major US listed companies, works. The advantage of this is that it accurately reflects the structure of the market and is relatively stable, as the weighting of large companies generally changes slowly. The disadvantage is that the performance of the index can easily be dominated by a few giant companies, so the investor’s exposure is actually less diversified than the name suggests.

In the case of price-based weighting, shares with higher prices are given greater weight. The Dow Jones Industrial Average is classically constructed in this way: the prices of the 30 individual shares included in the index are added together and then divided by a number called the Dow divisor. Historically, this method was easy to calculate, which is why it has survived for so long. However, the weights are quite arbitrary, as a higher-priced but smaller company may be given greater weight than a larger but lower-priced stock. Stock splits can further distort the weights.

 

Finally, equal weighting is more intuitive. Here, each component is given the same weight, regardless of price and company size. The advantage is greater diversification, i.e., less dependence on the largest companies. The disadvantage is that the largest capitalization “mega-cap” stocks are underweighted, and maintaining equal weighting requires frequent rebalancing, which increases turnover costs.

 

Three versions of the Dow on the same stock basket

Now let’s look at an experiment to show the differences. All three strategies started with $100,000 in initial capital on January 1, 2010. In the first case, we used the original price-weighted official weighting. In the second case, all current Dow components were given equal weight, with regular rebalancing. In the third case, we weighted based on market capitalization.

 

Comparison of results

Indicator	Price weighted Dow	Equal weight Dow	Market cap weighted Dow
Initial capital	100 000 USD	100 000 USD	100 000 USD
Final balance	632 908.75 USD	637 207.94 USD	752 691.97 USD
Net return	532.91%	537.21%	652.69%
Annualized return (CAGR)	12.29%	12.34%	13.52%
Maximum drawdown	−38.700 %	−33.200 %	−31.700 %
Sharpe ratio	0.529	0.551	0.585
Annualized volatility	0.142	0.135	0.142
Profit–loss ratio	1.39	0.73	1.61
Total trades	364	2 031	869

 

What does this mean in practice?

The price-based and equal-weighted Dow ended up almost exactly the same in the long term. The final balance and annualized return were practically identical. Equal weighting resulted in a slightly lower maximum decline and slightly better risk indicators but also meant significantly higher turnover and higher transaction costs.

In contrast, the market capitalization-weighted version clearly showed a better risk-return profile. The return was higher, the maximum drawdown was lower, and the Sharpe and profit-loss ratios were more favourable. Using the same thirty blue chip stocks, simply changing the weighting rule resulted in a significantly higher final balance.

The name of an index is therefore only partial information. It is not enough to know which stocks are included in it; it is at least as important to know the rules according to which the weights are distributed. The same universe with three different weighting logics provides three different investment experiences. It is the investor’s task to choose the weighting method that best suits their risk tolerance and goals.

 

The model does not fully replicate the original Dow methodology due to the simplified modelling approach.

 

 

 

Legal Notice: The operator of this blog is VIG Asset Management Hungary and the authors are employees of the Asset Management Company. This website contains commercial communication. The articles published on the blog reflect the subjective opinions of private individuals, are prepared for informational purposes only, and do not constitute investment analysis or investment advice, nor do they contain any investment recommendations. The authors of the blog may trade in their own name in financial instruments, funds, or other products about which they provide information or express an opinion in their articles. While the authors’ experience gained in stock exchange or over-the-counter trading may be reflected in their writings on this blog, such interests must not influence the information they provide. Articles, news, and information on the blog may feature companies that maintain business relations with VIG Asset Management Hungary or with the authors of the blog, either directly or through another company belonging to the VIG Group. The articles published on this blog do not provide complete information and do not replace the assessment of the suitability of an investment, which can only be determined by evaluating the individual circumstances of the given investor. To make a well-founded investment decision, please seek detailed information from multiple sources.

VIG Asset Management Hungary, the editors, and the authors of the blog accept no responsibility for the timeliness, possible omissions, or inaccuracies of the content on the blog, nor for any investment decisions made on the basis of the blog articles, or for any direct or indirect damage or cost arising from such investment decisions.