What is market capitalisation?

Market capitalisation or market cap is the main type of weighting method when it comes to valuing a stock market. One big question is ‘Why do we weigh our portfolios to market capitalisation?’

To understand what a market cap is, we first need to find the value of the stock market. Taking each company within the market, multiply the number of outstanding shares by the stock price and add the values of the stocks together. We can then compare the values from two different times, and we can see the market’s return. This percentage return reflects the overall change in the value of all stocks in the stock market. Once we calculate the value of the stock market, we can then see what the value is compared to other stock markets across the globe.

Other weighting methods don’t provide this insight. For example, an equally weighted index shows the return of the average stock but not the total market value. This is why capitalisation-weighted indices are important for investors; the S&P 500, for example, is a key indicator of the U.S. economy’s performance.

 

What about GDP?

Gross domestic product measures the monetary market value in one country, but it doesn’t reflect the market’s collective opinion of each stock’s value.

Consider Nestle, listed on the Swiss Stock Exchange, SIX, which accounts for 16% of the Swiss Index. If you were to buy the Swiss Index and hold positions in Nestle, this doesn’t mean you are betting on the Swiss economy, but rather a ‘bet’ on the growth in emerging markets. Growth in Switzerland accounted for less than 2% of company sales. In 2023, Nestle’s global sales share was 41% outside of North America and Europe. The highest organic growth reported by Nestle was in Latin America at 9.2%.

The market cap of Nestle is considered the best guess of its value represented in the market, as individuals are buying and selling Nestle shares. The market knows this and takes into account all public information available to market participants and reflects this in the share price, i.e., the research above. You don’t need to research each stock or country, as the market considers publicly listed information, which means you don’t need to pick an individual whose stock market performs well or individual stocks. Buying a globally diversified tracker is an important step towards your financial goals.

 

Market Capitalisation Weighted Indices

Indices have been used for economic analysis long before they became the basis for long-term financial goals. However, several features of cap-weighted indices make them particularly suited for index funds. The biggest advantage is that these funds are relatively easy and inexpensive to manage. Unless the underlying index changes, a well-constructed cap-weighted index fund doesn’t need to buy or sell stocks frequently. Changes in stock values are automatically reflected in the fund’s value, while other methods, like equal or factor weighting, usually require more trading.

Because cap-weighted indices need less trading, they can represent the entire economy and reflect the reality that not everyone can outperform the average, they remain difficult to beat. The world is everchanging, there are no fixed percentages, and these can change over time. For example, the UK had the largest stock market in 1900, at 24.2%. This year, the US is more than 60% and the UK is now 4%.

 

Home Bias – How to avoid it

Viewing the world through market capitalisation can help achieve diversification. However, there is a tendency to allocate more money to their domestic market rather than a global representation. For example, the average UK investor is 4.9x overweight to the market capitalisation of UK stocks. This is known as home bias. This is when your investments are more focused towards your domestic market and could be due to multiple reasons, such as a fear of unknown markets or a tendency to remain unchanged.  Some clients consciously choose to have a home bias. For instance, studies have shown that investors are typically more optimistic about the future of their home economies than overseas investors, which may have an impact on allocation choices.

Whether it is intentional or not, being fully aware of the implications of maintaining home bias is important. Tilting your investments towards a single market can increase return volatility. Take Hong Kong, for example, the annualised volatility of returns is greater than 30%, whereas the global market is less than 20% over 50 years. Hong Kong represents a tiny fraction, specifically 1% of the global market cap.

Domestic markets can be viewed with greater return volatility than the global market, which is why broad diversification across global markets can minimise volatility.

Another risk of overweighting one domestic market is other markets may perform better over any given period. Take New Zealand, for instance, they had the second-highest annual return out of the developed markets in 2020 with 20%. The following year they were the lowest, with -8%.

Over time, it is notoriously difficult to adjust a portfolio’s exposure to global markets based on whether regions, sectors, or particular stocks are likely to outperform. Investment portfolios can benefit from gains from whichever regional market is excelling at any given time, thanks to global diversification.

 

Sizing your portfolio to market capitalisation

Your decision to invest globally is the first step. An appropriate allocation for your portfolio using a market cap-weighting method results in spreading your investments globally at a low cost. As global markets evolve, a market cap-weighting will reflect any changes in your long-term investment. Financial planners potentially add value in this area, although each person is unique with their own financial goals and time horizons to quantify the potential add value. However, Vanguard’s study on financial advisors’ added value is up to, or even exceeds, 3% in net returns.

To learn more about how we can add value, read how financial planning can achieve your goals here, or schedule a meeting with one of our advisors, located in Central Hong Kong.