The United States stock market is often segmented by market capitalization. The market capitalization of a company is calculated by multiplying the company’s stock share price by the number of stock shares outstanding. Market capitalization, often referred to as market cap, is also used when referring to the size of a company. Large sized companies are large-cap; medium sized companies are mid-cap; and small sized companies are small-cap. The criterion for classifying companies into these categories varies somewhat by source. The common division is: large-cap companies are $10 billion or more; mid-cap companies are $2 billion to $10 billion; small-cap companies are less than $2 billion. Other classifications sometimes used are mega-cap for companies over $200 billion and micro-cap for companies under $300 million.
Standard & Poor’s is a major source for U.S. stock market indices. Standard and Poor’s classifies stocks based on the following: The S&P 500 Index tracks large-cap companies with a market capitalization of at least $5 billion. The S&P 400 Index tracks mid-cap companies with a market capitalization of $1.5 to $5.5 billion. The S&P 600 Index tracks small-cap companies with a market capitalization of $300 million to $2 billion. The number included in the index name indicates how many companies are included in the index. As you may have noticed, the category ranges have some overlap. This reduces frequent classification changes if a company’s market capitalization happens to fluctuate around one of the category break points.
The capitalization categories are not equally weighted across the total stock market. In the U.S. stock market, small-cap companies are greater in number; however, large-cap companies comprise a larger percentage of the total market capitalization. MSCI Barra is a company that produces several stock market indices. Their U.S. Large Cap Index includes 300 companies that represent approximately 71% of the total U.S. stock market capitalization. Their U.S. Mid Cap Index includes 450 companies that represent approximately 15% of the total U.S. stock market capitalization. Their U.S. Small Cap Index includes 1750 companies that represent approximately 12% of the total U.S. stock market capitalization.
The Russell U.S. Indices also demonstrate how a majority of the market capitalization is represented by large-cap stocks. The Russell large-cap index contains 200 companies that represent approximately 60% of the total U.S. stock market capitalization. The Russell mid-cap index contains 800 companies that represent approximately 28% of the total U.S. stock market capitalization. The Russell small-cap index contains 2000 companies that represent approximately 10% of the total U.S. stock market capitalization.
Morningstar is a company that provides investment research data. Morningstar’s definitions say that among the total stock market capitalization, giant-cap stocks comprise 40% of the capitalization, large-cap stocks comprise the next 30%, mid-cap stocks comprise the next 20%, small-cap stocks comprise the next 7%, and micro-cap stocks comprise the last 3% of the total market capitalization. Even though giant and large cap companies are fewer in number, the large size of those companies causes them to represent a greater percentage of the total stock market.
Market capitalization should be an important consideration when diversifying a stock portfolio. An investor who wants to be diversified similarly to the U.S. stock market would not invest in each capitalization category equally. That investor would place a greater percentage in large-cap stocks and a lesser percentage in small-cap stocks. Mutual funds with the objective of investing in the total stock market will usually be allocated among different sized companies to represent the total market. For example, Morningstar data indicates the Vanguard Total Stock Market Index Fund is approximately allocated 41% to giant-cap, 30% to large-cap, 20% to mid-cap, 6% to small-cap, and 2% to micro-cap. This fund appears to accurately represent the different market capitalization categories when compared to Morningstar’s total stock market allocation described in the previous paragraph. These total stock market funds are an easy way to diversify an investment by market capitalization.
An investor who chooses to diversify among different company capitalizations without purchasing a total stock market fund should be careful to hold different funds in the correct proportion. An investor would not be wise to place $10,000 in a large-cap fund, $10,000 in a mid-cap fund, and $10,000 in a small-cap fund. Doing this would cause the investor to be under-weighted in large-cap companies and over-weighted in small-cap companies. A better choice would be to place $21,000 in a large-cap fund, $6,000 in a mid-cap fund, and $3,000 in a small-cap fund. This would allow the investor’s portfolio to be diversified more like the total stock market. The performance of these three funds will likely be different over time, causing the percentage held in each category to change. To correct this, the investor should occasionally rebalance the portfolio through buying and selling in order to maintain the intended allocation.
The discussion so far has only considered the United States when referring to market capitalization. The United States represents less than have of the total global market capitalization. The Russell Global Index is composed of about 10,000 companies across 63 different countries representing 98% of the total global market. Of the 10,000 companies in the Russell Global Index, 3,000 are companies in the United States. Remove the United States from the Russell Global Index, and the remaining 7,000 companies represent 61% of the total global market capitalization.
A similar global composition is evident when evaluating the Dow Jones Wilshire Global Indices. The Wilshire Global Total Market Index contains stocks from almost 13,000 companies across 58 different countries with a total market capitalization of about $51 trillion. The United States contributes about 5,000 companies to the index with a sum market capitalization of about $20 trillion. The remaining $31 trillion in the other 57 countries represent about 61% of the total global market capitalization.
While many investors allocate their investment portfolios across different market capitalizations within the United States, most do not invest 61% of their portfolio outside the United States. This is because there are other criteria for allocation that go beyond the scope of this discussion. Investors who are seeking diversification by market capitalization can become adequately diversified within the United States market. For those seeking global diversification, investment outside the United States of 20% to 30% would provide sufficient global exposure.
Market capitalization is a major diversification guideline, but there are plenty of other ways to diversify. An investor might choose to diversify between stocks and bonds, between growth stocks and value stocks, between high quality bonds and high yield bonds, or between domestic markets and international markets. However an investor chooses to allocate, portfolio diversification should be a careful consideration.
Sources: Standard & Poors, MSCI Barra, Russell, Dow Jones, Morningstar
