Market Capitalization-Weighted Index

Definition

A Market Capitalization-Weighted Index (or Value-Weighted Index) is a stock market index where each component is weighted according to the total market value of its outstanding shares. * Formula: $Weight = \frac{Company's\ Market\ Cap}{Total\ Market\ Cap\ of\ Index}$ * Standard: It is the most common methodology used by major benchmarks like the S&P 500, Nasdaq Composite, and KOSPI.

The Logic (Size Matters)

The larger the company, the more influence it has on the index's performance. * Example: In the S&P 500, a massive company like Apple or Microsoft has a huge weighting. A 1% move in Apple's stock price will have a significantly larger impact on the index level than a 10% move in a smaller company like Etsy.

Pros

• Representative: It accurately reflects the "aggregate wealth" of the market participants. It tracks what the market actually thinks companies are worth.
• Stock Split Neutral: Unlike price-weighted indices (Dow), stock splits do not affect the weighting because the market cap remains the same (Price $\downarrow$ $\times$ Shares $\uparrow$ = Constant).

Cons

• Top-Heavy: The index can become dominated by a few massive tech giants (The "Magnificent Seven"). If these few companies crash, they drag the entire market down, even if the other 490 companies are doing fine.
• Momentum Bias: By design, it overweights overvalued stocks (bubbles) and underweights undervalued stocks, essentially "buying high and selling low" in terms of portfolio allocation.