The flaw of traditional market-cap indexing

Claymore Investments, Inc. 14 May, 2010 | 3:16AM

Despite all their benefits, traditional market-cap-weighted indexes can be flawed in a very fundamental way. Because market cap, or price, is linked directly with the weight of the stock in the index, as a stock's price increases, so does the weight of the stock in the index. Investors using these indexes are forced to allocate more of their portfolio in overvalued stocks and less in undervalued stocks -- exactly the opposite of what common-sense investing would suggest.

A great example of this for us here in Canada is the Nortel effect in 2000, when Nortel represented over 30% of the S&P/TSX Composite Index at its peak at the expense of many other great companies. In 2008, Research in Motion, Potash, Suncor and Encana made up 25%+ of the index just before the market corrected. The market doesn't always get it right, so why invest in market cap index strategies that assume it does?

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Claymore Investments, Inc.

Claymore Investments, Inc.