- Friday 28 August 2020
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One maths lesson I remember very well from school was about the difference between average and mean. Our teacher used the wages of professional footballers as an example, guaranteeing our interest, and explained that the average weekly wage was £1000, an astronomical figure for a bunch of 9 year olds in 1987.
The bubble was burst in explaining how the mean wage was a very different thing, as we understood for the first time that the salary of the very top players completely skewed the average, dampening our future lifestyle expectations even before our actual football skills finished the job.
Since then, I’m thankful to say, an understanding the impact of ‘outliers’, those data points on either end of a group range, when it comes to statistical analysis is something that I’ve retained and regularly find very useful as a call to be sceptical or at least careful when sensational headlines announce some new and amazing ‘average’ in the world.
MARKET CAP WEIGHTING: THE BEST DRAG THE REST
One area where the performance of outliers genuinely impacts the entire data-set is investing, specifically investing in an index, which is a constructed basket of shares and one of the fastest growing methods of accessing markets. This is probably where your pension and savings are.
More importantly, I am referring to an investment where the makeup of the index is determined by a concept known as Market Cap Weighting. These words may mean very little to the average investor, but they are probably the most important reason why pension and savings accounts have recovered their value in the 6 months since stock markets collapsed, and why the risk level inside indexes, usually considered the most diversified and therefore robust investment funds, has increased to levels not seen in decades.
EQUAL & MARKET CAP WEIGHTING INVESTMENTS
To show how a Market Cap Weighting works, let us look at how an index fund is created.
- Imagine a market has just 2 companies, AIB and BOI.
- Each company has 1,000 shares in the market and the share price is €1
- Each Company Market Cap (no. shares * share price) is €1,000
- The ‘Total Market Cap’ is €2,000, split 50/50 among the two shares.
An investment fund index that intends to replicate this market would obviously contain an equally weighted amount of shares from both companies. Any changes in price, would be reflected in the fund on a pro-rata basis. For example, with a €100 investment, if the price of AIB goes up 10% to €1.10, your fund will increase by €5% because half your investment is in AIB.
MARKET CAP WEIGHTING
- Assume the same companies and the same number of shares, 1,000, in each.
- This time, AIB is trading at €0.50 and BOI is trading at €1.50
- The ‘Total Market Cap’ is still €2,000, but now it is split €500/€1500 or 25%/75%between the two companies.
If we wanted to buy into this market with our €100, we can now choose two different strategies.
- Equal Weighted Fund: We spend €50 on 100 shares of AIB and €50 for 75 shares of BOI
- Market Cap Weighted Fund: We spend our money guided by the relative weighting, so €25 on 50 AIB shares and €75 on 50 BOI shares.
Choosing these strategies will deliver very different outcomes for our fund depending on what each share does:
AIB + 10%
BOI + 10%
Equal Weight Fund
Market Cap Weighted Fund
MARKET CAP WEIGHTING IN YOUR FUND
Of course any sensible investor or fund will have far more than just 2 companies, meaning the impact of one company’s share price is much lower. One of the reasons that ‘index funds’ are so popular with investors and advisors is that they contain a huge number of different shares, with many of the Global Equity Portfolios we offer holding upwards of 10,000 companies!
The other benefit of Market Cap Weighting as a strategy is that it is the “truest” form of Passive Investing there is. In comparison to Active Investing, where some type of consideration or input from a fund manager is required, this approach is genuinely hands-off, as the market itself dictates how the investment fund is constructed and maintained.
Decades of data show us that Passive Investing outperforms all other strategies over time, and Market Cap Weighting is the best form of passive investing as well as being the easiest strategy to implement. While the media and entertainment industry would imply otherwise, people are actually really bad at picking winners and the less involvement we have the better!
MARKET CAP WEIGHTING IN 2020
Of course it wouldn’t be 2020 if there wasn’t something strange and unprecedented happening in investment markets, just to add to everything else we’re dealing with at the moment.
Usually, in broad terms, a stock-market will follow a collective & cohesive path, where stocks rise and fall together. Indeed, to avoid experiencing the full volatility of the equity journey, part of building a sensible investment portfolio requires incorporating other assets such as Fixed Income (Bonds), Property and Commodities (Oil, Gold etc.) to create the risk profile you need.
So, in March, when markets collapsed, pretty much every stock in the markets fell. That makes intuitive sense.
However, during THE RECOVERY we have seen since then, not all individual stocks have risen – far from it. In reality, a very small number of the huge tech companies have seen their prices jump, most likely on the basis of our extra reliance on them in a Covid-world, but due to their size, that increase in prices has lifted the entire market, index and personal investment funds.
REASONS TO BE POSITIVE
Initially it was feared that the recovery in markets was reactionary and without substance, attributed to everything from Government intervention (true) to a lack of sports on the TV (less so). However as the big tech firms have posted their earnings in recent weeks, we see that there is genuine reasons that they have become so valuable and solid commercial likelihood of it being maintained.
Indeed, as our world shifts to one with much more online engagement between people, depressing as that may be in real terms, these companies are likely to prosper even further, driving their own share price and the values of the markets & indexes that hold them to higher and higher levels.
REASONS TO BE WORRIED
‘Don’t put all your eggs in one basket’…..
This chart shows how the value of the 5 biggest companies in the S&P 500 (the largest market/index in the world) is now equivalent to the bottom 282, a situation not seen in decades and usually preceding a ‘major correction’ (euphemism for significant fall).
If you can zoom in, do so. The companies on the left of the pie-chart are not SMEs but some of the most recognisable brands in the world. That they are dwarfed in size by the likes of Facebook and Alphabet (parent company of Google) is not something to celebrate as it shows a huge disconnect between the ‘real economies’ and this new online universe.
For investors, it means that the increase in the value of their investments has corresponded, and is directly connected to, a significant reduction in the level of diversification in their funds, which increases risk levels. For most investors this has happened without their knowledge and for Fund Managers & Investment Firms, points to a real dilemma over what to do.
WHAT WILL HAPPEN?
As always, that’s the multi-trillion dollar question and, as of right now, there is no clear indication one way or the other.
When I speak to investors at times like this, I point to the 2 scenarios that would impact most – the outliers in terms of likelihood and outcome.
- De-risk or exit markets now and then miss out on continuous growth as the tech firms and/or the other companies in the indexes go from strength to strength.
- Stay in the markets and a major ‘correction’ occurs, wiping out the recovery and resetting the market back to a more diversified weighting, but reducing your own investment value at the same time.
An investors decision, ideally guided by their advisor, should consider their emotional response to both these hypothetical events, but also (perhaps more so) their circumstances. Those with time to invest can afford the risk/reward balance of scenario 2, while people with less time should probably look at scenario 1.
There is no doubt we live in strange and troubling times, something that investors are adjusting to as well as the rest of us.