Capitalization Weighted Stock-Bond Allocations

This is for those who think in terms of the Efficient Market Hypothesis. Although I do not fall into that category, my intentions are constructive, not argumentative.

There are two strong points in favor of mutual funds indexed to the stock market as a whole (such as the S&P500 index and the total market index).

One is that they have inherently low costs. There is no need to buy or sell shares except when new money is put into the market or when money is taken out. Capitalization weighting automatically adjusts for normal price fluctuations.

The other point is that it is the optimal stock allocation under the Efficient Market Hypothesis. Or, at least, it is always very close to the optimal allocation.

If we go back to basics, optimal allocations should include more than stocks. The actual theoretical structure includes all investments. The optimal allocations, if not constrained by special real world considerations, should be capitalization weighted across the entire spectrum of investments. In fact, it should include all investments throughout the world.

Let us restrict oursleves to stocks and bonds.

If we are limited to stocks, we should use a capitalization weighting of the stock market. When we include both stocks and bonds, we should use a capitalization weighting of the combined markets. That is, the combination of everything in the stock market and in the bond market.

In particular, our allocations between stocks and bonds should vary in accordance with the relative capitalizations of the individual markets.

The Efficient Market Hypothesis leads to a variable stock and bond allocation.

Reference Site for Efficient Market Advocates

This is the best Efficient Market Hypothesis site that I have seen for those with a mathematical background.

John Norstad's Finance Page

Here is the key theorem that shows that Capitalization Weighting is NECESSARILY optimal assuming an Efficient Market OR Capital Asset Pricing Model OR Fama-French Factors.

Three Proofs that TSM is Efficient

Have fun.

John Walter Russell
October 12, 2006