If you have investments in any indexes (or, indices, if you prefer), time to listen up, because most indexes on the market today are capitalization weighted.
Capitalization weighted indexes are market indexes that have elements that are kept in proportion to their market capitalization. Let’s break that down.
You’ve heard of these: the S&P 500, the Nasdaq Composite. These indexes are weighted, meaning all the goodies inside them aren’t equally represented. Which is good, right? If Apple, Google, and Microsoft make up a large part of a tech-index, then you’d want to be more invested in them than equally invested in some tiny tech start-up that...might not make it.
Finding the value of a cap-weighted index is pretty straightforward. Just take the total shares x the price per share to get the market value, then compare market values.
For instance, if there was a two-stock index (hopefully not in real life) with company A having 100 stocks at $1 each and company B having 50 stocks at $5 each, that would mean A has a market value of $100 and B of $250. These companies will be proportionally represented in the index, so you’ll be more invested in B than A by 2.5x.
Makes sense...so why is this so important to know? Well, it means that, if there’s volatility among the big boys, the index you’re invested in will feel more like you put all your eggs in one basket rather than many. And if you’re invested in an index, it’s probably because you wanted some variety in your life, for risk’s sake. It also means that, if one company grows super fast, they may be suddenly taking up a huge amount of an index by weight, distorting the market...and maybe your investments in a sense, too.
The lesson: your index might not always be as varied and safe as you think it is. So wear protective gear and brace for impact.
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finance a la shmoop- what is compounding value or compounding interest? ah the
power of compounding. it makes trees stronger pollution more feral and the
rich well richer. how so well let's start with compounds kissing
cousin with six toes, arithmetic compounding. right so the first was [feet with six toes pictured]
really geometric compounding now we're talking about arithmetic compounding. if
you invest a thousand bucks in a ten-year bond that pays 6% of a year in
interest, the dough comes back to you in a pattern that looks like this - like
every six months they pay thirty bucks and it's $60 a year, got it? nice. you get
the total of sixteen hundred bucks back from your investment and the cash that
came back to you you know came in small parts all along the way, until you got [list of yearly returns]
about two thirds of it or sixty percent at the end right? if you just spent that
money and collected your thousand bucks at the end that's it. okay so that's
arithmetic compounding/ the money comes to you if you don't reinvest it.
ding-ding-ding that's the key here and you just go buy burgers. okay so now
let's look at what six percent compounded looks like over the same
10-year period .well at the end of year one it's a thousand sixty bucks and note
we're only gonna compound it annually we probably should do the semi-annually but [list of yearly compounds]
we'd confuse you even more so don't do that. but then you essentially reinvest
that money and you get another six percent compounded on that thousand
sixty , instead of six percent compounded against the original thousand. so by the
end of year two you'll have a thousand one hundred twenty three sixty. and by
the end of year ten you'll have one thousand seven hundred and ninety
dollars and eighty-five cents. so why do you make so much more money when you
compound interest versus getting 30 bucks twice a year like you would in
this bond example? go and find burgers with it? yeah .you don't want to do that
well essentially what's happening is that you're delaying your gratification [man in a drive through window]
of getting that sweet sweet cash or getting liquid whatever you want to call
it. by reinvesting your gains year after year after year. so do you have that sort
of self-control? do you need the cash yeah that's the question if you for
example have trouble making it home from your local pizza spot with the pie
in tact well then compound interest keeping the discipline to not spend the [man eats pizza while driving]
money today and wait for the happiness tomorrow well when that may not be for
you. sorry
Up Next
What is recapitalization? Pay attention the first time, there won't be a recap.