The story of Noah and his ark is a familiar one, rooted in the Book of Genesis. In this narrative, Noah is commanded by God to build a large wooden ark and gather two of every species on Earth before a massive flood wipes out all other life. The ark serves as a metaphor for an “equal weight index,” where each species is represented equally, regardless of its natural abundance.
The Ark as an Equal Weight Index
In nature, the population of larger animals is typically smaller than that of smaller ones, while insects are far more abundant than vertebrates. By saving just two of each type, Noah’s ark represents all species but does not reflect their true proportions in nature. When constructing a portfolio, one might consider taking a “Noah-like” approach by buying one unit of each asset type. However, this method would lead to unequal investments across different asset classes. For instance:
- Real Estate:One unit could be 100 square meters of land.
- Government Debt:One unit might be $1,000 worth of bonds.
- Equities:One unit could represent 0.01% ownership in a company valued at over $1 trillion.
This approach would require a massive portfolio and would not accurately represent the market since the value of land and companies varies significantly based on location and market conditions.
The Role of Money – a transaction enabler
A primary function of money is to assign a monetary value to products and services, allowing for easier exchange without constant negotiation. This system enables partial ownership; for example, you can invest $10 in various assets regardless of how much that amount represents in terms of actual ownership. Thus, it’s feasible to create a portfolio that includes $1 worth of every conceivable type of asset, effectively representing the market as an equal weight index—akin to Noah’s Ark.
Liquidity in Asset Markets
Most asset markets, particularly real estate, lack liquidity. Buying and selling large tracts of land involves numerous complexities such as verifying ownership, understanding tax implications, and incurring transaction costs. In contrast, financial assets are generally more “frictionless” and trade more frequently. This is why we often see indices based on financial assets rather than real assets. For example:
- S&P 500 Equal Weight Index:An equal weight index based on S&P 500 stocks.
- Nifty 500 Equal Weight Index:Another example using Indian stocks.
- Dow Jones Equal Weight U.S. Issued Corporate Bond Index:This index focuses on U.S. corporate bonds.
Market Capitalization vs. Equal Weighting
When considering how to represent various asset types, it raises the question: does it make sense to treat all species equally? As noted earlier, Noah’s selection was not representative of the actual diversity on Earth. In financial terms, if one had enough capital to buy every asset globally, the resulting portfolio would be skewed towards more expensive assets due to their higher market values. Market capitalization (market cap) refers to the total value of a company’s outstanding shares. When constructing a full market portfolio by purchasing all shares at their current prices, you create a market cap-weighted portfolio. Consequently, most indices—like the Sensex, Nifty 50, or S&P 500—are based on market capitalization.
Building Your Portfolio
In essence, a market cap-based index is the simplest way to “buy the market.” Investors can build portfolios by purchasing these indices across various asset classes. This approach serves as a foundational strategy for any investor looking to build a diversified portfolio. In our next column, we will explore a straightforward yet powerful investment strategy: creating a multi-asset class portfolio. If you’re interested in understanding the differences between market cap-weighted and equal-weighted indices in greater detail, check out my earlier column here!
