Did you know that the most major stock indices, such as those that are followed by the Thrift Savings Plan in the C, S and I Funds, are capitalization weighted? That means that the greater the value of the company’s outstanding shares of stock (market capitalization), the more of the index that particular stock takes up. In other words, larger companies make up a larger share of the investments.
One would determine the capitalization of a particular stock by multiplying the share price of a particular stock by the value of shares outstanding. Market cap weighting especially affects indexes that contain extremely large companies.
For example, it would affect the large-cap C Fund more than the small to mid-cap S Fund. One major exception to capitalization weighting can be found in the Dow Jones Industrial Average, which is price weighted (including an equal number of shares for each of the 30 companies that make it up).
The top five companies in the S&P 500 are currently Apple (4.36 percent), Microsoft (3.59 percent), Amazon (3.13 percent), Berkshire Hathaway (1.72 percent), and Facebook (1.58 percent) – comprising almost 15 percent of the index.
Over 30 percent of the S&P is comprised of tech stocks, and a new Communication Services sector that includes Facebook and Google parent company Alphabet.
In an index that is capital weighted, changes in the market value of the larger stocks move the index more than changes in the market value of the smaller stocks. In fact, four of the FAANG stocks (Facebook, Apple, Amazon, Netflix and Google) are in the S&P 500’s top ten and the remaining one is number 32 in capitalization.
As tech and communications stocks surged in the past few months it took the index along with it, but the risk is one of chasing trends, and exposure to flight from the tech sector. By comparison, a negative trend in industrials – taken in isolation – would only impact 9.7 percent.