Owning the whole market
Index funds, the S&P 500 and total-market indexes, and why a market-value-weighted index looks after itself.
FinanceBogle ch. 3About 4 min: 2 reading, 2 practiceUpdated
General education, not financial advice.
- Explain what a stock market index and an index fund are
- Calculate a company's weight in a market-cap-weighted index
- Explain why such an index doesn't need to trade when prices change
Common-sense investing: the case for index funds: lesson 3 of 13
- Bogle ch. 1
- The Gotrocks family 4 min
- Bogle ch. 2
- Where stock returns come from 5 min
- Bogle ch. 3
- Owning the whole market 4 min
- Bogle ch. 4
- Costs and the market return 3 min
- Bogle ch. 5
- Fund returns versus investor returns 6 min
- Bogle ch. 6
- Taxes are costs too 5 min
- Bogle ch. 7
- When future returns are lower 5 min
- Bogle ch. 8–9
- Why past winners rarely repeat 5 min
- Bogle ch. 10
- Paying for advice 5 min
- Bogle ch. 11–12
- Costs go on forever 5 min
- Bogle ch. 13
- Bonds and money-market funds 4 min
- Bogle ch. 14–15
- New indexes and ETFs 5 min
- Bogle ch. 16–18
- Graham, the arithmetic, and a plan 5 min
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Pairs with Bogle, The Little Book of Common Sense Investing (2007), chapter 3, "Cast Your Lot with Business"
What it is
Bogle's answer to the Gotrocks story is to own the whole market and hold it. That is what a broad index fund does: it holds the shares in an index, in the same proportions, and keeps them.
An index is a list of shares with a rule for weighting them. Bogle discusses two U.S. indexes:
- the S&P 500: about 500 of the largest U.S. companies. In Bogle's 2006 figures these made up about 80% of the value of all U.S. shares.
- a total stock market index: every U.S. company that trades, 4,971 of them in Bogle's 2006 figures.
Both are market-capitalisation weighted: each company counts in proportion to its total market value (share price × number of shares). Bogle reports that over 1926–2006 the two earned almost the same return (10.3% and 10.1% a year), because the largest companies dominate both.
Bogle invokes Occam's razor: when several solutions work, choose the simplest. Owning everything is the simplest way to own all of business.
Quick check
Tap an answer to check it.
In a market-cap-weighted index, which company has the biggest weight?
- Weight is by total value (price × shares), not price alone
Show answer
The one with the largest total market value. Weight = company value ÷ total value of the index.
Why it matters
A cap-weighted index fund doesn't need to buy or sell when prices move: its holdings rise and fall in value exactly as the market's do, so it stays in step automatically. Little trading means low costs and few taxable gains, which is the Gotrocks family standing still.
Worked example
An index of three companies:
| Company | Market value | Weight |
|---|---|---|
| A | 600 | 600 ÷ 1,000 = 60% |
| B | 300 | 30% |
| C | 100 | 10% |
| Total | 1,000 | 100% |
Now B's share price doubles. B is worth 600, and the market 1,300:
- A: 600 ÷ 1,300 ≈ 46.2%
- B: 600 ÷ 1,300 ≈ 46.2%
- C: 100 ÷ 1,300 ≈ 7.7%
An index fund that held the same shares as before now has exactly these weights too, because its shares of B doubled in value along with everyone else's. It didn't have to trade.
Common mistake
Thinking an index fund must constantly rebalance as prices move. A cap-weighted fund rebalances itself; it trades mainly when companies join or leave the index, or when money comes in or goes out.
Key terms
- index
- a list of shares with a rule for weighting them
- index fund
- a fund that holds the shares of an index in the same proportions
- market capitalisation
- share price × number of shares: a company's total market value
- cap-weighted
- each company counts in proportion to its market value
- S&P 500
- an index of about 500 large U.S. companies
- Occam's razor
- when several solutions work, choose the simplest
Practise the key terms
Tap a card to turn it over. 6 cards.
| Front | Back |
|---|---|
| index | a list of shares with a rule for weighting them |
| index fund | a fund that holds the shares of an index in the same proportions |
| market capitalisation | share price × number of shares: a company's total market value |
| cap-weighted | each company counts in proportion to its market value |
| S&P 500 | an index of about 500 large U.S. companies |
| Occam's razor | when several solutions work, choose the simplest |
Practice
Work it through
An index holds three companies worth 500, 300 and 200. Company C (worth 200) rises 50% in value; the others don't change.
- 200 × 1.5
- 500 + 300 + 300
- 300 ÷ 1,100 × 100
Quick quiz
Tap an answer to check it.
Why did Bogle's S&P 500 and total-market figures move almost together?
- The total market holds thousands more, but they are small in value
Show answer
The largest companies, which are in both, make up most of the value of each. Cap weighting gives the big companies most of the weight in both.
A company's share price rises. What must a cap-weighted index fund do?
- Its holding has already grown with the price
Show answer
Nothing: its holding has grown in value along with the company. Cap-weighted funds keep in step without trading.
In short
- An index fund holds all the shares of an index, in proportion, and keeps them.
- Cap-weighted: weight = company value ÷ total value.
- Price changes don't force trades; the fund stays in step automatically.
- Bogle: the simplest way to own all of business (Occam's razor).
Mastery check
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Check yourself
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How do you find a company's weight in a cap-weighted index?
Show answer
Divide its market value by the total market value of the index.
Why does a cap-weighted index fund trade so little?
Show answer
Price changes move its holdings in step with the index, so it only trades when the index's list changes or money flows in or out.
What share of U.S. stock market value did the S&P 500 cover in Bogle's 2006 figures?
Show answer
About 80%.
Further reading
- John C. Bogle, The Little Book of Common Sense Investing (John Wiley & Sons, 2007), chapter 3.
- Investor.gov: Index Funds, the U.S. SEC's plain-language page on index funds.
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