Capitalization Weighting of What?

This exposes the underlying fallacy related to Sharpe’s Theorem that capitalization weighting matches the return of the market as a whole. It incorporates Dr. Hussman’s observation that money can never enter nor leave the market as a whole.

What has been missing? What is the critical oversight? Dividends.

Two Theorems

Dr. Sharpe proved an important investment theorem: If you take the market as a whole, capitalization weighting matches the average return of the market. Some people do better. Some people do worse. In a statistical sense, beating the market is a hopeless task. In a practical sense, capitalization weighting is the ideal choice since there are no transactions necessary to maintain capitalization weighting.

There are subtle fallacies underlying the main conclusion: that capitalization weighting is the ideal choice. The most important fallacy is ignoring that different investors have different needs with different timeframes. Retirees, for example, are often willing to accept a lower return for a guaranteed lifetime income stream.

Dr. Hussman proved another important theorem. Money never enters or leaves the stock market. All dollars invested to buy shares of stock come out of the market as dollars removed by the sale of those shares. The net is always zero.

Each day, prices change as buyer and sellers reach agreement. There is never an imbalance between buyers and sellers at the transaction price. At any instant, there are lots of imbalances between bid and asked prices.

A Closed System

The market as a whole comes very close to being a closed system. Both theorems are true. How can we do better? What is the hidden fallacy?

Dividends.

Consider a company that retains all of its earnings. Its total return comes from price changes. On average, relative to the market, its capitalization should grow.

Consider another company that pays substantial dividends. If it produces the same total return, its capitalization cannot grow as much. According to capitalization weighting, it is inferior. Its weighing must get smaller.

What happens is that the dividend payments come out of the market as a whole. Dividend payments are applied to all of the stocks, when using capitalization weighting. Retained earnings stay within a single company.

We don’t really have a closed system. Money DOES leave the market. It leaves in the form of dividends.

Increasing Your Total Return

You can increase your total return if you take this distortion into account.

Define your investment candidates with dividends in minds. Only then should you apply capitalization weighting.

And what does this mean? Limit your trading activity. Don’t buy and sell unless you have a good reason. Rebalancing is not one of them. Capitalization weighting is a great idea WHEN you take dividends into account.

Have fun.

John Walter Russell
October 22, 2006