The Two Tier Stock Market - Its Implications for Portfolio Management

Marshall E. Blume

Rodney L. White Center for Financial Research Working Papers from Wharton School Rodney L. White Center for Financial Research

Abstract: A large number of articles in the popular financial press have highlighted the substantial differences in the returns from equal-weighted and value-weighted indexes over the last several years. Thus, an equal-weighted Value Line Composite Index declined 64.8 percent from March 11, 1968, to September 30, 1974, while the value-weighted New York Stock Exchange (NYSE) Composite Index declined only 33.2 percent over this same period.

In trying to explain these differences, many observers have postulated the existence of the two, or even more, tiers in the market place. According to these observers, different types of stockholders confine their investments to specific tiers. The argument goes on that in recent years institutions have been channeling their huge amounts of new funds into a limited number of so-called favored stocks and thereby supporting their prices. Since these stocks, which constitute the upper tier, are generally stocks with larger market values, the recent differences in returns between equal-weighted indexes are said to be explained.

An alternative explanation, but not the only alternative, is that equal-weighted indexes are inherently more risky than value-weighted indexes and that the observed differences in returns on these two kinds of indexes in recent years are consistent with their differences in risk. The purpose of this paper is to analyze the risk and return characteristics of indexes of NYSE stocks under various weighting schemes starting in 1928. Following this analysis is a discussion of the implications for portfolio management.

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