By Michael Khouw
Publication Date: 2025-11-28 15:30:00
In equity markets, returns and market capitalization do not follow a normal distribution. Instead, they exhibit heavy-tailed, right-skewed, power-law characteristics: A very small number of companies account for a very large share of total wealth creation, while many (or even most) companies underperform. At a high level, this is because the potential growth of the biggest companies is “unlimited”. A shareholder can make many multiples of their initial investment, while, in the worst case, they have limited liability if a company goes bankrupt and can only lose the amount they initially invested. According to one study , the top ~4% of stocks generate all net long-term wealth creation while the median stock massively underperforms the index. Virtually every investor is familiar with Nvidia (NVDA) , Apple, Alphabet, Microsoft, Amazon, Meta, Tesla, Berkshire and Eli Lilly — the S & P 500’s 10 largest constituents. They might not realize that those companies delivered orders of magnitude more total return than the average constituent. A cap-weighted index fully captures these extreme right-tail winners in proportion to their success because their respective contributions to the index’s investment performance are functionally related to their size. As a stock’s market cap rises, its weight in the index automatically increases, and underperformers shrink in weight. We can observe this effect by comparing the total returns of two indices, both comprised of the same stocks,…
