Last post on this topic (at least for a while). Click on the following links for Part I, Part II, and Part III.
The final thoughts I wanted to share with you about this refer to the assumptions under which market cap-weighting an index suffers a drag when linking portfolio weight to price. We have already shown that overpriced stocks will be overweighted and underpriced stocks will be underweighted. These mispricings happen in every sector, and in every size of stock (small-, mid- and large-caps). How do we know which are overpriced and which are underpriced? We never know. No one knows what “fair value” is for any stock. But because the market has so many participants we assume that prices tend to revert towards fair-value more often than not. This does not preclude the market from getting prices drastically wrong at times, but with so many participants these mispricings are eventually identified and this is acted upon by the market and the result is the reversion to fairer prices.
So let me throw this out there to you: If the market is efficient enough that you can’t reliably outperform it, then is it fair to say that the market will tend to revert to fair prices on average? If it is fair to say that, then is accepting the drag of the price-weight link a necessary evil?
That’s an easy question, as phrased: the answer is yes, it’s a necessary evil. If you can’t outperform the market, then anything you do to try to correct these “mispricings” can’t, by definition, help you outperform the market!
Can weighting be based on volume?
(just something that popped into my mind)