What’s Wrong with an Equal-Weighted Portfolio?

So this is a fun one. Do you guys know what the smallest holding is within the S&P 500? I do not. Nope. It's Paramount Skydance, at least as of the end of January. So if you look at the market capitalization weight of Paramount and the market capitalization weight of NVIDIA, NVIDIA's 1300 times larger, give or take in terms of its market capitalization weight. So if you put those on equal footing, this is basically equivalent to if you had a global equity portfolio that was putting the same amount in the United States and Peru. Yeah, but Peru smoked it a couple years ago. It's true, maybe this will back test really well. Peru also has three stocks, so it's like, okay, do you put all that capital there? So this is also, by the way, the same ratio between the height of my toddler and the Burj Khalifa Tower. So you wouldn't use those two interchangeably as height measurements, you probably wouldn't do the same thing with Peru and the United States. So that's just something to keep in mind about some of the unintended consequences of equal weighting. Welcome to The Informed Investor where we break down the latest financial headlines, bringing in research and insights to help you separate the news from the noise. Question of the day, is every stock the same? Meaning should I have the same weight in every stock in my portfolio? Welcome to The Informed Investor, I'm Mark Gochnour joined today by Wes Crill and Jake DeKinder. You wanna take your first shot at my question? Is every stock the same? Before we came on, I was just laughing at that. Like is every stock the same? No, that's a dumb question. You're kind of yes though, guy. You answer a lot of these that way. I'm pretty like black and white on some things, man. These episodes would be way shorter if we just had you doing the content. Yeah, but then we wouldn't have like all of the great insight from you and all of the data and all the things that people actually care about. And the jokes. You bring a lot to this show, I don't bring much to this show. I believe that investment content is maximized when it sits at the intersection of entertaining and informative. See, even that sounds smart. Geez. Geez, I know. Just say something funny. I know, God, man. All right, headlines. First one, equal weight ETFs are back in style. Next one, this is a little bit long, so bear with me here. But why the equal weight S&P 500 doesn't make sense for long term investors. Right, two great ones here on equal weight strategy. So, hey Wes, why don't you start us out here and just give the context of sort of this idea of a market cap weighting versus an equal weighting. And then we'll talk a little bit about why we're hearing so much about an equal weighting strategy. Yeah, I liked that first headline noted that this is back in style, meaning this is something that we've seen before and it has kind of been peppered throughout my career at Dimensional. So one of the, if you think about where you would start, like how would you answer the question of how much you wanna hold in different stocks? Well, a logical place to start is how much the market is effectively holding in all of these, what are the market capitalization weights, and that makes sense from an intuitive standpoint. If you think about what market capitalization weights are tied to it's market price. What do we know about market prices where they're forward looking? It's the market's aggregate assessment about the outlook for these companies or for the market as a whole. And so market capitalization weights are effectively the aggregate trade off the market has landed on in terms of risk and return. So it seems like a logical starting point. Now, there's also the advantage of sort of a self rebalancing mechanism here where if market prices go up for companies, then their weight in the overall in a market capitalization weighted portfolio is gonna go up. And so if you wanted to tie yourself to market capitalization weights, you already have more by virtue of that price movement. And so that's sort of been, I think what the baseline would be for a lot of people to start out with. And then equal weighting is clearly gonna be a divergence from that. He just sort of got into your answer to the question of is every stock the same? You said no, it's a dumb question and you just said yeah, the market thinks it's a dumb question too because stocks have such, such different valuations. Yeah, do you think of a company that's going into bankruptcy as being the same as NVIDIA or Apple? Probably not, there's gonna be differences in securities and the market clearly feels the same way. Well, not only are not all the companies the same, but kind of what you would expect to make on all the companies the same. And Wes kind of answered that question right there, right? We know that there's a relation between what you pay and what you expect to get. We know that we've seen the data of securities that increase in price over time than looking forward as a whole tend to have lower expected returns. So not only from like is the company the same, would you wanna put all the same amount of money into it? But from a pure research and expected return standpoint, no, they're not the same. So let's bring into those headlines we just read, which is, well then why would you want an equal weighted strategy, right? So the market says, here's what these stocks are worth. There's been headlines here about, well maybe you don't want that, you want every stock to have the same weight. And I'll go back where I've seen this come up a couple different scenarios. One was kinda in that last decade time period when S&P 500 was doing pretty poorly, it was slightly negative over that ten year time period. And you're hearing about that strategy then of equal weighted strategies make a lot of sense because you have way less weight in the underperforming stocks over that time period and more weight in smaller value stocks, which did really well. So one was, Hey, S&P did bad, so you should equal weight those stocks. And now we're hearing about it as, hey, you should equal weight the S&P 500 because these max seven stocks, some of these largest companies to become so big, maybe it's a way to reduce some of the exposure to those big companies. Why would you wanna deviate in the first place? I already laid out the foundation for why market capitalization is a logical starting point. Why would you wanna deviate? Well, there might be a couple of reasons. It might be you wanna pursue higher expected returns in the market, or you have goals or preferences in mind that would lead you to want less of certain companies than the market would hold. And so then the question is, well what's the best way to approach that? I think this is where one of the challenges with equal weighting that's kind of come back into popularity is, okay, what that implies is you're setting all of the companies within a given sort of parent index or investment universe on equal footing. And that's where you can get into some really strange outcomes. Because if you think about, okay, well the top 10 companies say the S&P 500 is about 38% of the index. Well, with equal weighting, it's now gonna be 2%, right? So that's where you get into some strange phenomenon where you can have a smaller company in the index is gonna be vastly overweighted relative to its market capitalization weight, and a really large company is gonna be less. Now, that might directionally, be a reasonable sort of objective because if you are say, concerned about concentration in some of the top names in the US market, maybe you would wanna have less of them, but how much less, that's gonna be an interesting proposition. Yeah, again, that concept of, do you take some money and shift it from some portion of the market into some other portion of the market? I mean, shoot, that's a lot of what the research says, if you want to go after higher expected returns. It's just do you go all the way to making everything equal? Because even within the S&P, that's a massive shift from the biggest companies down into the smallest companies. And if you look at the percentages on that, it's crazy how much you actually would shift that weight. Well it's, yeah. So this is a fun one, do you guys know what the smallest holding is within the S&P 500? I do not. Nope. It's Paramount Skydance, at least as of the end of January. So if you look at the market capitalization weight of Paramount and the market capitalization weight of NVIDIA, NVIDIA's 1300 times larger, give or take in terms of its market capitalization weight. So if you put those on equal footing, this is basically equivalent to if you had a global equity portfolio that was putting the same amount in the United States and Peru. Yeah, but Peru smoked it a couple years ago. It's true, maybe this will backtest really well, Peru also has three stocks. So it's like, okay, do you put all that capital in there? So this is also, by the way, the same ratio between the height of my toddler and the Burj Khalifa Tower. So you wouldn't use those two interchangeably as height measurements, you probably wouldn't do the same thing with Peru and the United States. So that's just something to keep in mind about some of the unintended consequences of equal weighting. I told everybody to invest in Peru and if you're gonna concentrate man, go for three stocks. I mean, just go for it. Where's this tower you just mentioned? It's in UAE. Okay, I'll have to look it up. It is currently the tallest. I always forget what the qualifications around this are. It's not the tallest structure in the world because there's radio towers that are taller. It's the tallest occupied building that's currently open. Is that the one that was in Mission Impossible? Yes. Now you know it. Now I know. There's one under construction in Saudi Arabia that's gonna be even taller, a kilometer tall, called while the Jeddah Tower. Yeah. Some serious engineering. Wow. There's some smart people out there. Alright, let's go back to your example, NVIDIA and Paramount Skydance. So you're just saying that that deviation is so massive by a market cap weighting, but then in an equal weighted S&P 500 strategy, it's saying we're gonna put 2%- Gonna be on equal footing. In each one of those different companies. So I always think about this in terms of, hey, what are you trying to accomplish? Kinda going back to the goal and why you might want to weight some of these top stocks lower. But then you gotta look at the cost side of things too, the implementation side of it. So what are some of the implications of an equal weighted strategy? I mean, if you're saying, Hey, I gotta kind of keep this right at 2% for every stock, like that's a serious amount of turnover, you would think, right? And transaction costs and buying and selling to do that. Yeah, no, that's a really good point about the cost. And again, I mentioned one of the appeals of market capitalization weighting is that kind of self rebalancing where you don't have to do trading every time the price goes up of a company. If you're trying to keep everything at equal weights, every time a price changes for one company, then you gotta do buying and selling across the portfolio. So obviously there's things in practice that you can do with an equally weighted strategy that would cap some of that, but just by definition, it's likely to have higher turnover than market capitalization weights. That's not the only cost. You think about what are some of the other costs to which investors are sensitive? Well, one of them is tax impact and we know there's about, I think just short of 30 REITs that are in the S&P 500. And so if you're gonna equally weight those, all of a sudden, you're gonna have a bigger weight in REITs about three times larger weight in REITs than you would in market capitalization weighting. What do we know about REITs? Well, they potentially have higher tax costs for investors because of the income they throw off. So that's another consideration there where it's like, okay, if my objective, going back to the original question is to have less exposure to certain companies, maybe pursue higher expected returns, is that the most effective way to do it? It reminds me of some of like, the prescription drug commercials you see on television, which is let's solve for A, but then you're gonna have B, C, D, E issues over here that maybe were the unintended consequences. And I think you brought up a good point, which is, is it the best way to kind of go about it or have you thought about all of these other things that might create some issues for you that you didn't expect? All right, you know I love talking about taxes. I know you do. So I wanna go back to your income comment just to. I knew I'd cheer you up with that one. Yeah, I understand that one. So you're talking about REITs where one REITs have a high yield, so that, but then also all that income is taxed as non-qualified income. So it's taxed as the highest ordinary tax rate rather than the 20% dividend rate. So that's really important because one might say, yeah, in if it's an ETF format, you might be able to maintain some of the capital gains associated with perhaps turnover a little bit more effectively in an ETF. But the income, you're still stuck with that. That's a good point. ETFs don't help you with that, yeah. They'll help you defer potentially capital gains, not gonna do anything for your income. Yep, so you see some of that tax differential on an ETF, you can still have a big tax cost from that REIT income, I just wanna to be clear about that perspective of it. So Jake, going back to your comment then, so if you do want to perhaps reduce some exposures to these big top companies out there, what might be some better ways to think about doing that? Well, I mean, what are the better ways to do that? I mean, first off, do you really want to just, if your goal would be to go after higher expected returns, are you just gonna limit yourself to operating within the S&P 500? Because we know that there are thousands of other stocks as I start to move down into mid cap, into small cap, as I start to think about moving into the value space. So I think you're almost right off the bat limiting your, if you're saying, okay, I don't like the idea of there's concentration of the top, so I wanna shift some weights. I like the idea potentially going after higher expected returns, but I'm just limiting myself to the S&P 500. I mean right there, you've kind of constrained yourself when you might have other options and better ways to go about it. And if we start talking about this idea of small does a little bit better than large, value does a little bit better than growth, right? Are we really thinking about how all these things kind of interact and play together? Because it's so easy to say be like, I'm gonna solve this problem and I'm gonna buy an equal weighted S&P 500 fund. But there's all of these other things you have to consider if you truly wanted to design a strategy that is solving for those problems. Yeah, absolutely. I mean, again, if your goal is to pursue higher expected returns, well we do have a ton of research around what kind of characteristics are associated with differences in expected returns. And if that is your goal, then you can still start with market capitalization weighting and then just overweight some stocks in a way that is like systematic, it's because it's tied back to market cap weight, you get that benefit of sort of the natural rebalancing and you can pursue higher expected returns. But to your point, if you're doing that directly rather than backing into those kind of tills through equal weighting, you're in a better position to manage the trade-offs associated with it. Like we've heard a lot of news around value traps, what that might imply is there's low price companies that have lower profitability. Well, if you are deviating in a systematic way where you're taking into account the profitability in addition to market capitalization and price to book, then you can do that in a more sort of reliable and robust way, pursue higher expected returns. And by the way, along the way, you also get sort of the lower exposure to those top companies in the market, which again, if that's your goal, you get that as a side benefit. Well also too, you now would have more control over how much you would wanna accomplish with that, right? I mean you go and you buy this equal weighted S&P 500, sort of the decision's made for you on how much you're gonna shift from the big ones to the smaller ones within that S&P universe, right? If we go down this path that we're talking about, you have more control over how much would I wanna deviate from market? Because there's a lot of different flavors within there, right? It's not just a simple, you're either market cap or you're equal. There's a lot in between that. You can take a decision on how you want to tilt, to smaller value and profitability away from market weights. And then also of course, investing outside the US, great way to diversify and reduce some of the exposures of those top companies, if that's what your goal is. One of the reasons we're talking so much about the S&P 500 is because most equal weighted strategies do reflect some form of the S&P 500 because, think about that. If you got, what, the Russell 3000, let's say the 3000 stocks out there, that gets really small, if you equal weight a 3000 stock portfolio. What is that? What would that weight be? Divide by 3000, is that like 0.003? How tall is that tower? Yeah, I was gonna say at that point, you're building a space elevator. No, it's a good point. I mean the single largest ETF that's equally weighted does track the S&P 500 and I think that's a good point. You go back to like, okay, is that the extent of your opportunity set? Well no, we have a global opportunity set. Once you start getting into other segments of the market, then you can see even more the limitations of equal weighting and why you would wanna have a systematic approach towards your weighting scheme that to your point, it's controlled, you know what you're gonna be getting. It's more consistent in terms of the over and under weights for different segments of the market, whereas an equally weighted might be bouncing around depending on the prices of companies. Also, I hate to always be cynical, but I'm gonna come back to the marketing angle, right? I mean, what is a name that a lot of people know? They know S&P, right? So if you want to go out and you wanna sell some products, what are you gonna do? You're gonna be like, Hey, I'm gonna bolt onto the name that everybody knows, I'm gonna pitch this concept of equal weighting, which again, I think you brought up a great point, going back to sort of the 2010s, which was a real big part of how it was marketed, but you always gotta kind of put that hat on of, are they just selling you a product? And if you had a need, which is investors have needs, I get that. But just be careful that you're not being pitched a product that really isn't the best way to go about accomplishing your need. Well, and these headlines often generate emotions, right? Completely. And part of it might be, hey, S&P's done poorly, you can do better, let's equal weight. Or Hey, I'm worried about these big stocks, whatever they go down, let's reduce risk. I got a headline here I wanna run by you guys related to some of the emotions around the investing in the headlines. All right, now this would've came out February 1st, 2026. How long can equal weighted ETFs keep outperforming the S&P 500? Right, what was the time period equal weighted outperformed the S&P 500? I was gonna say, there's no way that headline could have been in December, which hill sort small cap and value in the US. So yeah, that sounds like very short term performance. Small in values underperform for many years, it had a great month in January and now all of a sudden, the headlines are coming out. Like can this persist? It's been one month. One month, yeah. But that gets into the conversations we've had a lot, which is investors sadly have a very short horizon. And I think when you follow a lot of these headlines, you think about that, you're one month of outperformance. Should I do it? Is it gonna continue? I mean shoot, I remember a couple of years ago, remember that article that we read about the average holding period within retail brokerage accounts and it was like seven or eight months? I mean it was under a year year. It was less than a year, yeah. It was a really short holding period. So I'm not surprised that after one month of equal weighting doing well, they're out there pitching that. And sadly, I think a lot of people are, huh, maybe I should go into that. Well that's why we started the show, right? Is people are reading these headlines and let's just bring some, I guess a sense of it to these headlines. Try to remove the emotions from it in terms of what's gonna give you the best investment experience over time. Because people do make decisions based on these headlines. We're trying to get them above the fray, as it were. Which is an article you write, I love that subtle self-promotion there. Yeah, I mean, you know me and marketing, I love it. Well it is an excellent article by the way, Above The Fray. Oh, thank you. You do a nice job with that. All right, so listen, if I'm an investor and I'm reading these headlines about equal weighted strategies, a couple things to keep in mind for me. One, you can rethink your weighting scheme and there's very efficient ways to do that, not only from a strategy but also implementation. How much you should have in these different areas of the market, that could be tough for investors to determine that. So get a financial professional that can help you think through that and find the most efficient ways to capture, depending what your goals are. Capture those tilts. And then just be careful of headlines on some of this stuff, right? Dive into it before you just react to a headline. What else? No, you nailed it. I mean I think we hit a lot of the points there. And again, the last one's good too. Just be careful on the short term performance. I mean almost everything, not everything, a lot of what you read is, hey this is interesting over the last month or the last three months or the last six months, so let me write an article to kinda grab your attention. Maybe don't pursue that in terms of investment approach. Not all stocks are the same, not all stocks have the same expected returns. Nailed it. That's the answer of the day. Just 'cause indices are indifferent to the stocks doesn't mean you have to be. All right, well thanks everybody for joining The Informed Investor. A future topic we're gonna dive into is gonna be talking about bonds and the different needs, the different goals you might have and how bonds can help you think through those goals. Also be sure to check out the survey, we are definitely looking for your feedback on future topics on The Informed Investor. Thanks for joining, have a great rest of the day.