Wedemeyer wrote: ↑Thu Jun 17, 2021 10:11 am
The thing I still struggle with is the concentration of the weighting in few companies. It make sense to me that the market cap weighting is the market value of the price to pay today. But for investing, we want to diversify across assets that will grow in value to get the best return. The general consensus on this website is no one knows what the market will do on the future, other than the market will yield market returns. Using CRSP definitions, the market return is heavily (~70% in US) reliant on the 200 or so largest companies, ie the megacaps. Since no one knows if megacaps will outperform large (non megacap), mid, and small over a time period, then it is possible that large, mid and small could outperform the megacaps over a time period. No one knows.
So I land on tilts towards large (non megacaps), mid, small, and small value, which I feel is better diversification.
Your thoughts are appreciated.
So I very much like thinking in terms of investing in ownership shares of assets, but consider the following.
Assume there are 1000 assets. They are not identical and have different risks, but let's just say when those risks are accounted for, they are all worth $1000 each. So, the total pool of assets is worth $1,000,000.
OK, so now assume three companies, A, B, and C. A owns 800 of these assets, and has a market cap of $800,000. B owns 160, and has a market cap of $160,000. And C owns the remaining 40, and has a market cap of $40,000. We're just assuming here the assets they owns determines their market value. We're also assuming away any liabilities for simplicity sake.
OK, You have $1000 dollars, and want to invest it in shares of these 1000 assets. And assume you have no reason not to just put $1 in each.
If you follow that logic, it implies you should buy shares of A, B, and C at market weights. So, $800 in A, $160 in B, $40 in C.
OK, you now argue, but I don't know if Company A will outperform B! Or B will outperform C! Why am I investing so much more in A than B, and B than C?
Well, in this model, if you invest more in C than market weight, you are concentrating your investment disproportionately in those particular 40 assets, rather than just doing $1 each. And by hypothesis, you have no reason to do that. Same with if you invest more than market weight in B.
I think this is all a pretty powerful logic. If you think of yourself as investing in the underlying assets, and think market cap is tied to those assets too, then it doesn't matter much whether companies are bigger or smaller, it just means they have more or less of the assets you are trying to invest in.
But, there may in fact be subtle ways in which this model is wrong. But before you vary from it, you will need good reasons to do so.