Price vs. market-cap-weighted portfolio diversification: does it matter?

We analyse the diversification profiles of price-weighted and market-capitalisation-weighted portfolios. For that purpose, we compare the historical diversification levels of the Dow Jones Industrial Average (DJIA) and the Standard and Poor 500 (S&P500) indexes across three sets of portfolio diversification measures in different market regimes. We document different properties of the diversification measures, especially during crisis periods. To compare the indexes with different number of constituents we propose a novel approach called Exploited Diversification Potential (EDP). Our results suggest that the DJIA exploits its diversification potential better than the S&P 500. More generally, simulations show that price-weighted portfolios outperform market-capitalisation-weighted portfolios in terms of diversification potential. This result is robust to different portfolio cardinalities, simulation baskets, and sample selection cut-off periods.