An index fund promises to own "the whole market" in a single move. The promise rests on a quiet rule: each company weighs in proportion to its stock-market value. As long as that value is spread out, the index is a real basket. The day a few stocks crush it, the same basket becomes a concentrated bet, without any rule having changed.
1 Market-cap weighting
The rule that silently decides the content of almost every index fund.
Definition
Weight follows market value
In a market-cap-weighted index, each company counts in proportion to its size on the stock market, that is, the share price times the number of shares. A company worth a trillion weighs a thousand times more than one worth a billion. The fund that replicates the index therefore buys in those proportions: it puts the most money where there is already the most value.
2 The free float
A technical refinement that does not change the overall logic.
Free-float capitalisation
Only the shares actually tradable are counted
In practice, indices use the "free float": only the shares genuinely available to buy count, excluding those that are locked up, for instance held by a founder or a state. This adjusts each company's exact weight, but does not alter the principle: the largest still dominate. The free float refines the measure; it does not correct the concentration.
3 When the basket narrows
The same rule can produce real diversification, or extreme concentration.
Content matters more than count
If value is spread across hundreds of companies, the index truly spreads risk. But if a handful of stocks concentrate most of the capitalisation, the same rule sends most of the money toward them. The fund keeps its five hundred lines, yet a major share of its performance now depends on a few names. Diversification is not guaranteed by the number of stocks, but by the distribution of their weight.
4 Idiosyncratic risk
The risk diversification is meant to erase, and which returns through the door of concentration.
Two risks, not one
①
Market risk. The one that hits everyone at once: a recession, a crisis. You cannot erase it by diversifying.
②
Idiosyncratic risk. The one specific to a single company: a product that fails, a leader who leaves. By holding many companies at comparable weights, you dilute it almost entirely.
③
The return of specific risk. When a few stocks weigh a third of the index, their individual risk stops being diluted: a single misstep at one of them is enough to move the whole. The risk diversification was meant to smooth away comes back to the fore.
This is the heart of the paradox: a highly concentrated index reintroduces, inside a "diversified" product, the specific risk of a small number of companies. The investor believes they are betting on an entire economy; in reality they are betting on the trajectory of a few companies, often tied to the same sector and the same story.
5 Takeaways
A few sentences to remember.
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A market-cap-weighted index puts the most money where there is already the most value.
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Diversification depends on the distribution of weights, not on the number of lines held.
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Heavy concentration brings idiosyncratic risk back inside a supposedly diversified fund.
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"Passive" does not mean "risk-free": you have to know what the index really holds.
This notion illuminates these analyses