The Disadvantages of Modified Capitalization Index

by Walter Johnson

Market capitalization is the amount of money in stock represented by outstanding shares on the market. The Dow Jones Industrial Average and others, however, do not take this as representing the real capital on the market. This is because all capital is not the same. Some firms are larger, more active and more powerful than others. Volatility in major stocks has far more impact than volatility in minor stocks. Therefore, the modified and weighted indices were developed, and, as of the time of publication, there are many types.

Modified Indices

The modified capitalization index is a form of weighted indexing to give a qualitatively accurate picture of the market at any given time. To simply add the amount of capital on the stock market would lead to a lopsided picture. Therefore, a modified index will choose those specific stock areas that will serve as a benchmark for the others. However, this can also give a distorted picture of the market, since it ignores more minor stock and specific issues of importance to them.


The NASDAQ 100 tracks the 100 largest and most actively traded stocks on the market. This gives a more accurate picture of the market only relative to the largest firms. However, while it stresses the qualitative market -- in that the larger stocks have more impact -- it does not give a picture of the whole. If you, as in investor, are following the NASDAQ 100 or even the small-capital Russell 2000, all you are getting is returns from the larger -- or smaller -- sectors of the stock market. It ignores nearly everything that is not part of its specific purview. In other words, it gives only those indicators to the firms it seeks to track, whether it be large, small or foreign.


There is a bias in all forms of weighted or modified capital indices. The assumption of the NASDAQ 100 or the Dow Jones Industrial Average is that the larger the firm, the more impact it must have. This assumes, in turn, that small to medium sized firms are not important to the market or to investors. Even more, it implies that a small business is not expected to develop the innovations or inventions necessary to further its industrial sector along. It is assumed that only the larger firms are capable of this.


The modified methods of calculating market capitalization, almost without exception, deal with those firms that are actively traded. In other words, the higher the volume of trade, the better the chances that firm has for reaching that specific weighted index. This creates yet another bias. It assumes that if a firm is traded at a heavy rate, this rate will -- or should -- have a significant impact on trading in general. If a firm is stable, and sees little trading and much stockholder loyalty, it is considered unimportant to the broader market. It is almost as if these forms of indexing assume that the less stable the firm's stock, the more significant it must be.

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