Equal weight investing is an investment strategy that aims to reduce the volatility of a stock portfolio by assigning equal weights to each stock. Unlike market capitalization weighted indexes, the equal weight approach prevents a few large stocks from dominating the portfolio. By spreading investment evenly across companies, sectors, and market caps, equal weight indexing seeks better diversification and lower risk. This strategy has gained popularity in recent years as a way for investors to access the broad stock market with less exposure to large tech giants. Overall, equal weight investing provides a simple yet effective approach to build a diversified, balanced portfolio.
Equal weight investing lowers concentration risk compared to market cap weighted portfolios
In a cap weighted index, a handful of the largest companies take up the bulk of the portfolio. For example, the S&P 500 is heavily concentrated in a few mega-cap tech stocks like Apple, Microsoft and Amazon. This leaves the index vulnerable to the idiosyncratic risks of just a few companies. An equal weighted S&P 500 provides far greater diversification with less dependence on the largest stocks. By weighting each stock equally, exposure is spread evenly across companies of all sizes rather than concentrating in a few giants. According to S&P Dow Jones research, this has resulted in lower volatility over time compared to the cap weighted benchmark.
Equal weight strategies provide balanced sector exposures
Market cap weighted indexes tend to be overweight in the largest sectors of the market, such as technology in recent years. Equal weighting instead provides a more balanced sector allocation because companies of all sizes have equal representation. Studies have found that equal weight indexes have significantly different sector compositions compared to their cap weighted counterparts. For example, equal weight indexes allocate substantially more weight to cyclical sectors like industrials and materials while being less weighted toward dominant sectors like technology and consumer discretionary.
Equal weight investing can reduce concentration in growth stocks
In a cap weighted index, fast-growing companies see their weight rapidly rise as their market cap grows. This results in indexes becoming overweighted in expensive growth stocks during bull markets, adding risk when these stocks fall out of favor. However, growth stocks do not gain an outsized footprint in equal weight indexes since new entrants begin with equal weighting. According to research, equal weight indexes have tended to provide superior downside protection during growth stock declines due to their value tilt.
Rebalancing provides a systematic contrarian approach
Equal weight indexes rebalance on a quarterly or annual basis, trimming allocations in stocks that have outperformed and adding to those that have lagged. This forces the strategy to sell high and buy low – the essence of contrarian investing. Studies have found rebalancing is a key driver of outperformance in equal weight indexes. By taking chips off the table in winning stocks and increasing exposure after sell-offs, rebalancing acts as a systematic buy low, sell high discipline.
In summary, equal weight investing provides a straightforward approach to build a diversified portfolio that spreads risk evenly across companies instead of concentrating in mega-cap stocks. By reducing concentration risk and increasing diversification across sectors, market caps and growth/value styles, equal weight strategies aim to improve a portfolio’s risk-return profile.