The Problem of Capitalization-Weighted Indices
I often recommend to friends who don't have time to research stocks or mutual funds, but want to build an investment portfolio, that they engage in dollar-cost averaging using well known stock indices. After reading a truly excellent frontlinethoughts letter, I now understand that the index used should not be capitalization weighted.
Here is a summary of the reasoning as quoted from the May 13th Mauldin letter, all based on the work of Rob Arnott:
(Assume that) every asset is trading above or below true fair value. We can't know what true fair value is. But we can know that every stock, every asset, every bond is going to be trading above or below what its ultimate true fair value is. Even the most ardent fans of the efficient markets hypothesis would say, "That's reasonable. That's reality."BTW, if you don't like the term "fair value", substitute "future value", and the logic remains the same.
Now if every asset is trading above or below its true fair value, then any index that is capitalization-weighted, (price-weighted or valuation-weighted) is automatically going to have us overexposed to every single asset that's trading above its true fair value and underexposed to every single asset that's trading below its true fair value.