It seems to be more common these days to hear statements like “market capitalization is a bad way to invest” or “market cap is a flawed measure.”
Let’s back up a moment and remind ourselves what market cap is.
The argument that follows can be applied to equities, to bonds, to real estate or to anything else. Or it can be applied to a subset of these markets, such as corporate bonds or small cap equities. But once you’ve decided what is in and what is out, market capitalization equals the aggregate of every investor’s holdings of that particular set of securities.
So investors in aggregate hold a market cap portfolio, and investors in aggregate earn the same return as the market cap return. That’s not an approximate relationship or one that holds “over time” or “on average”; it’s a relationship that is an absolute and immediate upshot of the definition of market cap.
It is this feature that makes market cap unique, and from which market cap derives its validity.
Sometimes you’ll see other arguments in favor of market cap: it does not require rebalancing of holdings when prices move; the Capital Asset Pricing Model (CAPM) implies that it is the optimal investment portfolio. But those are not what make market cap special. So arguing against CAPM as an argument against market cap is like saying that because car drivers do not wear blindfolds, there’s no need to be careful crossing the street. (Let me set out the logic of that claim: if every car driver wore a blindfold, then you would need to be very careful crossing the street. So if I can prove that car drivers don’t wear blindfolds, I’ve undermined the argument for looking both ways, right? Not really.) That market cap happens to be optimal under certain (unrealistic) assumptions might be seen as nice, but it’s not really the main point.
What’s more, the value assigned by the market to a security reflects the balance of how attractive that security is to each investor. If investors find a security attractive at a given price (perhaps because they believe it is going to deliver a good return, or they like the income it provides, or they value its diversifying effect in their portfolio) then they are likely to buy it and that should push the price up. If they don’t like it (perhaps it is illiquid, or too risky, or engaged in a business activity of which they disapprove) then they will sell it, and that should push the price down. The market price is the balancing price.
So a market is a brilliant aggregation mechanism. James Surowiecki’s The Wisdom of Crowds lists three conditions for groups to reach good collective decisions: diversity, independence, and an effective means of aggregating views¹. The first two of these may be present to a larger or a smaller degree in any particular investment market at any point in time, but when it comes to the aggregation mechanism, an open market is about as good as it gets.
So where does that leave us? First of all, market cap is not flawed. As a representation of a market, it is always and invariably the best measure, because it is the market. It follows that market-cap-weighted indices are usually the best tools to use for performance benchmarking purposes.
However, market cap is an output of the actions of investors, and it is not necessarily appropriate to make it an input, i.e. to invest passively in line with the market cap. Ideally, your investment decisions should be based on your own particular circumstances and a thoughtful assessment of a security’s value. So the case for index-tracking is really a cost argument; if you think that you will not be able to do a better job than the aggregate of other investors, then you can save time and money by mimicking their decisions instead of making your own. That argument seems to me to be a lot more convincing in some areas than in others. But that’s a story for another day.
The bottom line is that market capitalization is unique because it captures the aggregate of the experience of every investor. It does not follow that it is necessarily an optimal strategy for any particular investor. But it has a special magic nonetheless.
¹Surowiecki, J (2004). The Wisdom of Crowds. Doubleday.