Measuring and reducing the risk of loss is always a concern of equity investors, but it has become virtually an obsession for many since the 2008–09 market drop. The key to reducing risk is appropriate diversification (investing in a basket of stocks rather than a mere handful) and getting position sizes right.

For the purpose of this article, we’ll look at the impact of various security-weighting schemes on the return of one well-known and well-diversified basket of stocks, the S&P 500, over the past 16 years. The relationships, we find, have positive implications for actively managed as well as indexed portfolios.

Like many capitalization-weighted indices, the S&P 500 tends to be dominated by the largest-cap stocks. Sometimes, though, these stocks become the largest-cap because of excessive increases in their valuations. As a result, investing in these indices may lead to buying high and selling low: the opposite of every investor’s goal. ....