Equal Weighting Is the Hardest Part

Equal Weighting Is the Hardest Part - stock

Big bets don’t scare me. One of my first big bets was made from an Internet cafe in Ghana.

For me, this Internet company was different. Its service was something I used every day, allowing me to find exactly what I was searching for on the Internet every time. Before this, Internet search was horrible. This company had no competition. Other than its programmers and its computer servers, it had no costs. And it was being used worldwide. Even in West Africa, everyone was using it. Now, the company was selling shares to investors for the first time through an initial public offering (IPO).

It seemed like a sure thing to me, but most people were skeptical. And it was easy to see why. The Internet bubble had popped in 2000. Wall Street had taken junky companies and sold shares in them, destroying the wealth of so many people. No wonder most investors stayed away even when a really good company’s shares were being sold.

Long story short … I took about 25% of everything I owned and bought Google’s IPO at $85 in August 2004. I don’t own it anymore, but the shares of Google are up 1,400% since then, making it a stock market superstar.

Everyone wants big gains. Now, unless you want to dedicate your life to analyzing and figuring out markets like me, your best bet is to diversify your portfolio. But it’s critical to do it smartly so that you get the highest return possible and still get a shot at some of those high flyers.

When it comes to diversifying your entire investment portfolio, my friends Jeff Opdyke and Ted Bauman tell you to use gold and collectibles to go beyond financial investments. That’s good advice. Some of my money is in gold, and my collectibles portfolio includes gold coins. And then it’s a bit unconventional. I collect antique gadgets — telephones, cameras, typewriters, gramophones and radios from the early 1900s.

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Equal Weighting Is the Hardest Part - stock

Now, when it comes to stocks, you can get instant diversification by buying an index fund like the SPDR S&P 500 ETF (NYSE Arca: SPY). That’s an OK way to diversify. But there’s a smarter way to diversify that I bet you’ve never heard of. The great thing about this way of diversifying is that you get the safety of being diversified and you get a huge increase in returns. For example, in the current bull market, you’d have made 82% more using this way of diversifying.

Better Returns, Same Risk

You see, when you buy an index fund, you’re diversifying through buying a basket of stocks. For example, the “regular” S&P 500 is a basket of 500 of the largest companies trading in U.S. stock markets. Here’s the key thing for you to understand. The S&P 500 is cap-weighted. Cap weighting means that you end up owning more of the biggest companies within the basket.

In the S&P 500, Apple has a market value or “market cap” of around $607 billion. Apple will have a larger effect on the S&P 500’s movement than toymaker Mattel with its $11 billion market cap. That’s because the S&P 500 is market-cap-weighted. Apple is given a higher weighting — 3.25% of the index compared with Mattel’s 0.06%.

Turns out there is a smarter way to diversify the basket of stocks in an index. It’s been proven smarter, because the index goes up more. Way more. And it’s not riskier.

Take a look at this chart of the S&P 500 comparing equal weighted (green line) against the cap weighted (blue line) for the current bull market.

Score: Equal-Weighted S&P 500: 282%. Cap-Weighted S&P 500: 200%.

SPX weighted - Equal Weighting Is the Hardest Part - stock

By simply changing the amounts of stock in the index, you can get 82% more in return, which is pretty great if you ask me.

Don’t Put All Your Stock in One Basket

Equal-weighted means that every stock in the S&P 500 has the same weight in the index — 0.20%. Big stocks and smaller stocks are treated equally. In a bull market, most stocks are going up. So the equal-weighted index goes up more than the market-cap-weighted version because in many cases smaller stocks will make sharper, faster moves higher than larger stocks.

Don’t get me wrong. You definitely want big stocks in your portfolio. But you want newer, fast-growing stocks that can zoom up like Google too. If you use smart diversifying tools such as an equal-weighted index fund, you get the best of both worlds — the safety of big stocks and the growth of newer, smaller companies all in one.

Bottom line: If you’re going to own stocks, be smart in your diversification of positions. The way to do that is to buy an exchange-traded fund (ETF) that uses equal weighting.

For example, if you want to own an equal-weighted version of the S&P 500, there’s the Guggenheim S&P 500 Equal Weight ETF (NYSE Arca: RSP). For diversification among 1,000 companies, there’s the PowerShares Russell 1000 Equal Weight ETF (NYSE Arca: EQAL).

Regards,

Paul Mampilly
Editor, Profits Unlimited