Equal, Value and Volatility Weighting

Once you have chosen what to hold, you must decide how much of each. The three most common weighting schemes are equal weighting, market capitalisation (value) weighting and volatility weighting. Each embeds a different view: market cap weighting trusts the market's pricing, equal weighting avoids concentration in the largest names, and volatility weighting focuses on balancing risk. The choice can change returns and risk as much as the choice of holdings.

Comparing the three#

Market cap weighting#

Most major indices, such as the S&P 500, weight companies by market value. The largest companies dominate: in recent years, the top 10 stocks have made up roughly a third of the S&P 500. Strengths: low cost, low turnover and it reflects the market as a whole. Weakness: it automatically holds more of whatever has risen most, increasing concentration during bubbles. See What Is an Index? and Concentration Risk.

Equal weighting#

Each holding gets the same weight, rebalanced periodically. Equal weighted indices give more weight to smaller companies, and the regular rebalancing sells winners and buys losers. Historically, equal weighted US indices have outperformed cap weighted ones over some long periods, partly from size and value tilts, but with higher volatility and turnover, and they can lag badly when large companies lead. See Size Factor and Rebalancing.

Volatility weighting#

Weights are proportional to the inverse of each asset's volatility, so calmer assets get larger weights. This is a simple step toward risk parity, ignoring correlations. See Risk Budgeting and Risk Parity.

Other schemes#

Choosing a scheme#

Traders and weighting#

Active traders face the same choice in position sizing. Equal dollar sizes across very different instruments, such as a utility stock and a small biotech, produce very unequal risk. Volatility based sizing, using ATR or standard deviation, keeps risk per position consistent. See Volatility and ATR-Based Sizing and Position Sizing.

Frequently asked questions#

What is the difference between equal weight and market cap weight?#

Market cap weighting holds companies in proportion to their size; equal weighting holds the same amount of each, giving smaller companies more influence.

Is equal weighting better than market cap weighting?#

Neither is always better. Equal weighting has outperformed in some periods and lagged in others, with higher turnover and costs.

What is inverse volatility weighting?#

A scheme that sets each weight proportional to one divided by the asset's volatility, so less volatile assets get larger weights.

Next, learn how to balance risk including correlations in Risk Budgeting and Risk Parity.