Help me understand pro/con of market weighting

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MrBeaver
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Help me understand pro/con of market weighting

Post by MrBeaver »

Full disclosure, I tend toward the slice and dice camp with some sector overweighting as a relatively young person. But I’d like to make sure I fully understand the arguments involved.


Here is what I think I understand:
  1. EMH says that all asset classes are fairly valued for their implied risk and reward (beta).
  2. Market weight holdings therefore ‘correctly’ weight different sectors given the global demand for the various securities based on the average risk profile of all world investors. Total world investors maintain that the best weight between countries/sectors/classes/etc. is the total world weighting.
  3. Almost nobody chooses their stock/bond mix based on total market weights, and instead choose a mix based on their risk profile, taking into account the beta of stocks vs bonds.
If the above three are true, I’m confused. #2 suggests that everyone should hold a similar risk profile of securities in their stock allocation, while #3 suggests that everyone should choose their allocation knowing that their risk profile is different than the combination of all global investors.

I have heard the suggestion that overweighting low-beta stocks or sectors/classes is worse than simply increasing one’s bond allocation combined with a market weight equity portfolio to hit a target risk profile.

But assuming someone is young and wants to be aggressive (100% stock), what is the coherent argument for steering them toward regional or global market weights even if their desired beta (risk/return mix) is higher than the average of all global equity investors?

In other words, why not overweight higher beta asset classes if one’s target risk profile is higher than the average of all equity investors?
HEDGEFUNDIE
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Re: Help me understand pro/con of market weighting

Post by HEDGEFUNDIE »

You may want to read this article to better understand the theoretical underpinnings of modern portfolio theory, and its weaknesses.

http://docs.edhec-risk.com/mrk/000000/P ... dexing.pdf

Just one comment on your last question. According to MPT, the proper way for a risk-tolerant investor to increase returns beyond 100% risky assets is not to overweight a particular “risky” segment of the market (as that would be violating the CAPM); rather, it is to borrow money to buy more of the full market portfolio.
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steve321
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Re: Help me understand pro/con of market weighting

Post by steve321 »

On the subject of beta (mentioned in the OP), I am reading at present the work of Nassim Nicholas Taleb. He has a different understanding of risk and of portfolio construction. To illustrate his take on it, I will quote one of his recent tweets:
Last night I dreamed that I was given The job at the Federal Reserve. I walked in and announced that 1) every economist with an academic origin would be laid off, 2) every statistician who used "variance" in a research paper would be immediately terminated.
Success does not bring happiness. In fact, happiness IS success. | 'There are only two tragedies in life: one is not getting what one wants, and the other is getting it.' Oscar Wilde
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steve321
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Re: Help me understand pro/con of market weighting

Post by steve321 »

HEDGEFUNDIE wrote: Mon Oct 08, 2018 11:16 pm According to MPT, the proper way for a risk-tolerant investor to increase returns beyond 100% risky assets is not to overweight a particular “risky” segment of the market (as that would be violating the CAPM); rather, it is to borrow money to buy more of the full market portfolio.
But, on the subject of borrowing money to buy stocks, didn't Buffett say there are three ways to go broke: 'liquor, ladies and leverage'?
Success does not bring happiness. In fact, happiness IS success. | 'There are only two tragedies in life: one is not getting what one wants, and the other is getting it.' Oscar Wilde
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alec
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Re: Help me understand pro/con of market weighting

Post by alec »

steve321 wrote: Tue Oct 09, 2018 1:59 am
HEDGEFUNDIE wrote: Mon Oct 08, 2018 11:16 pm According to MPT, the proper way for a risk-tolerant investor to increase returns beyond 100% risky assets is not to overweight a particular “risky” segment of the market (as that would be violating the CAPM); rather, it is to borrow money to buy more of the full market portfolio.
But, on the subject of borrowing money to buy stocks, didn't Buffett say there are three ways to go broke: 'liquor, ladies and leverage'?
That’s why it’s more risky than 100% risky assets portfolio.
"It is difficult to get a man to understand something, when his salary depends upon his not understanding it!" - Upton Sinclair
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vineviz
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Re: Help me understand pro/con of market weighting

Post by vineviz »

steve321 wrote: Tue Oct 09, 2018 1:59 am
HEDGEFUNDIE wrote: Mon Oct 08, 2018 11:16 pm According to MPT, the proper way for a risk-tolerant investor to increase returns beyond 100% risky assets is not to overweight a particular “risky” segment of the market (as that would be violating the CAPM); rather, it is to borrow money to buy more of the full market portfolio.
But, on the subject of borrowing money to buy stocks, didn't Buffett say there are three ways to go broke: 'liquor, ladies and leverage'?
There’s a fourth way: taking investment advice from billionaires.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch
UpperNwGuy
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Re: Help me understand pro/con of market weighting

Post by UpperNwGuy »

steve321 wrote: Tue Oct 09, 2018 1:41 am On the subject of beta (mentioned in the OP), I am reading at present the work of Nassim Nicholas Taleb. He has a different understanding of risk and of portfolio construction. To illustrate his take on it, I will quote one of his recent tweets:
Last night I dreamed that I was given The job at the Federal Reserve. I walked in and announced that 1) every economist with an academic origin would be laid off, 2) every statistician who used "variance" in a research paper would be immediately terminated.
Nassim Nicholas Taleb is the man who has advocated the barbell technique of putting most of one's investments into "boring cash" while investing the balance in very risky, maximally risky securities.

And, as you can see from the quoted tweet, he's an intellectual who loves to trash other intellectuals.
rkhusky
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Re: Help me understand pro/con of market weighting

Post by rkhusky »

A market-cap index fund owns the same percentage of shares of each company, as the percentage of shares each company has issued relative to all shares in the market, irrespective of the share price.
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steve321
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Re: Help me understand pro/con of market weighting

Post by steve321 »

UpperNwGuy wrote: Tue Oct 09, 2018 6:12 am
steve321 wrote: Tue Oct 09, 2018 1:41 am On the subject of beta (mentioned in the OP), I am reading at present the work of Nassim Nicholas Taleb. He has a different understanding of risk and of portfolio construction. To illustrate his take on it, I will quote one of his recent tweets:
Last night I dreamed that I was given The job at the Federal Reserve. I walked in and announced that 1) every economist with an academic origin would be laid off, 2) every statistician who used "variance" in a research paper would be immediately terminated.
Nassim Nicholas Taleb is the man who has advocated the barbell technique of putting most of one's investments into "boring cash" while investing the balance in very risky, maximally risky securities.

And, as you can see from the quoted tweet, he's an intellectual who loves to trash other intellectuals.
yes I agree, he's a professor and he trashes professors...; what I like though is the 'skin in the game' stuff; I remember even Descartes wrote that one should trust more people who have 'skin in the game' (though he didn't use those words) than professional philosophers who can just bs all they want, and have nothing to lose.
Success does not bring happiness. In fact, happiness IS success. | 'There are only two tragedies in life: one is not getting what one wants, and the other is getting it.' Oscar Wilde
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nisiprius
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Re: Help me understand pro/con of market weighting

Post by nisiprius »

One-sided discussion follows. In my personal opinion, attacks on market cap weighting are often amplified by the self-interest of those making the attacks. Not only does Vanguard have the lion's share of basic cap-weighted total market mutual funds, but, thanks to Vanguard's competition, there isn't a lot of money to be made in cap-weighted total market index funds by anyone. You gotta have a gimmick, and claims that departures from market cap weighting are superior to market cap weighting are a good gimmick.

John C. Bogle pointed out in Common Sense on Mutual Funds that all of the early editions of Jeremy Siegel's Stocks for the Long Run said that cap-weighting was optimal. He then changed--at the same time that became a participant a firm, WisdomTree, that sold mutual funds based on a non-cap-weighted "fundamental index" developed by Siegel.

The pros of market cap weighting all stem from the fact that it mirrors the actual composition of the market. The market itself is cap-weighted. There's just no way around that. Under a set of assumptions that are neither fully realistic nor utterly crazy, according to financial economics theory this makes it mean-variance optimum, but to me there are other convincing arguments in favor of it.

The big one for me is that cap-weighting cancels out the effect of speculative trading on my portfolio. A cap-weighted portfolio passively participates in the growth of the stock values of growing companies. Every other weighting implies partial participation in speculation. Every other weighting means you are taking sides, you believe that your weighting is reflects a shrewder valuation of stocks than those of other participants, and that in addition to profiting from the growth of the market, you are going to get an additional return by taking money away from other investors. If you are wrong, of course, they are going to take money away from you. Many of the arguments by fundamental indexing, factor strategists, and "smart beta" proponents acknowledge this, and state reasons as to why their strategies can continue to take money away from other investors even after other investors know that they are doing it, and know how they are doing it; I find it hard to judge the plausibility of those reasons; you must judge for yourself.

Another point is that cap-weighted portfolios are self-rebalancing. In theory, once you are cap-weighted, there is no need to buy or sell any stocks to maintain cap-weighting. Thus, transaction costs are low. This is a point that's surprisingly hard for people to grasp, and it is often intentionally misrepresented by people attacking cap-weighting. For example, suppose Facebook were to double in price and become 2.8% of the market instead of 1.4%. People often suggest that index funds would need to run out and buy more of this now-possibly-overprice stock. That's nonsense. They would need to do nothing of the sort. Simply by holding their shares, making no purchases or sales, the price of the shares they already hold would double, and the dollar weight in their portfolio would double from 1.4% to 2.8% simply because of that. (The funds that would need to run out and buy more would be factor funds with commitments to the "momentum" factor).

Another point is that cap-weighted total market investing is the only strategy that cannot become overgrazed. In a thought experiment, small-cap value is only 2% of the market so it is not possible for everyone to have 20% of their portfolio in small-cap value. If everyone tried, eventually the supply of small-cap value stocks would dry up and scarcity would boost their price. Cap-weighted investors remove all stocks from the market proportionally, and even in theory their activity does not change the relative plenty or scarcity of the stocks in the market.

The arguments against cap-weighting take advantage of the fact that many investors aren't clear on what the dollar-weighted composition of the stock market looks like. They can be easily surprised when someone says that the ten largest stocks account for 20% of the market, or that the thirty stocks in the Dow Jones Industrial Average account for $7 trillion / $32 trillion = 22% of the market. They then claim that this represents a "concentration" in large caps, which is like saying that seawater has a huge "concentration" of water, or that we are breathing air that is "concentrated" in nitrogen.

It is perfectly true that a cap-weighted total market index fund (blue) is going to behave similarly to an S&P 500 index fund (orange), which in turn is going to behave similarly to a Dow Jones Industrial Average ETF (green). The market is the market. The total value of the market is determined by where the money in it is is, and investors put most of their money in the largest stocks. Morningstar classifies total market index funds as "large-cap blend," and should. The market mostly is large-caps, so large caps act like the market and the market acts like large-caps. You can say that in a sneering tone of voice and say "isn't that awful," but that doesn't necessarily make it awful. Indeed, for every guru who says you ought to overweight small-cap value, there is another one touting large-cap growth (usually in the form of an active fund)... and there are a lot of investors who want a portfolio of exclusively "blue chips."

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HEDGEFUNDIE
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Re: Help me understand pro/con of market weighting

Post by HEDGEFUNDIE »

nisiprius wrote: Tue Oct 09, 2018 7:39 am The pros of market cap weighting all stem from the fact that it mirrors the actual composition of the market. The market itself is cap-weighted. There's just no way around that. Under a set of assumptions that are neither fully realistic nor utterly crazy, according to financial economics theory this makes it mean-variance optimum, but to me there are other convincing arguments in favor of it.
Yes, the theoretical conclusions of MPT state that the market cap-weighted total market of risky assets is mean-variance optimal. But here’s the wrinkle: the “total market” as contemplated by MPT is not just VTSAX. It’s all risky assets, including foreign stocks, bonds (yes these are considered risky assets in MPT just like stocks, and we are all supposed to hold them at market weight), real estate, commodities, private equity, art, wine, even human capital.

Equity index funds are only one slice of the pie, and without all of these other assets in the mix it’s not clear to me why a market-weighted VTSAX would still be theoretically mean-variance optimal. Perhaps a different weighting of stocks could be more optimal, to make up for the lack of those other [unobtainable to the average investor] assets.

To extend your analogy, it’s as if a scientist gave you a recipe to recreate the atmosphere, but all you could find was nitrogen, so you just run your experiments on nitrogen and tell everybody that your findings are supported by atmospheric theory.

I agree with your behavioral arguments, though.
Last edited by HEDGEFUNDIE on Tue Oct 09, 2018 10:48 am, edited 2 times in total.
2015
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Re: Help me understand pro/con of market weighting

Post by 2015 »

It's a great way to gasconade yourself into losing money.
People think that if they build the perfect model or if they have better information, then they will be able to beat the market.
It doesn’t work this way because there is one input that can’t be modeled and it’s arguably the one that matters most: How people will feel in the future. Investing is as much an exercise in psychology as it is accounting.
https://www.aaii.com/journal/article/le ... -investors
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