What is a price-weighted index?
A price-weighted index is a stock market index in which each company included in the index represents a fraction of the total index proportional to the share price per share of that company. In its simplest form, adding the price of each share to the index and dividing it by the total number of companies determines the value of the index. A security with a higher price will have more weight than a security with a lower price and, therefore, will have a greater influence on the performance of the index.
Key points to remember
- In a price-weighted market index, the stocks of each company are weighted by their price per share, and the index is an average of the stock prices of all companies.
- Price-weighted indices give more weight to stocks with higher prices in terms of their contribution to the value of the index and changes in the index.
- A price-weighted index can be used to track the average price of stocks in a given market or industry.
Understanding a price-weighted index
In a price-weighted index, a security that goes from $ 110 to $ 120 will have a greater effect on the index than a security that goes from $ 10 to $ 20, even if the percentage change is greater than that more expensive title. Higher-priced stocks have a greater influence on the overall direction of the index or basket.
To calculate the value of a simple price-weighted index, find the sum of the stock prices of individual companies and divide by the number of companies. In certain averages, this divider is adjusted in order to maintain continuity in the event of a stock split or a change in the list of companies included in the index.
Price-weighted indices are useful because the value of the index will be equal (or at least proportional) to the average share prices of the companies included in the index. This allows the construction of indices that will track the average performance of the share prices of a specific sector or market.
One of the most popular price-weighted stocks is the Dow Jones Industrial Average (DIJA), which is made up of 30 different stocks or components. In this index, higher-priced stocks move the index more than lower-priced stocks, hence the price-weighted designation. The Nikkei 225 is another example of a price-weighted index.
Other weighted indices
In addition to price-weighted indices, other basic types of indices include value-weighted and unweighted indices. For a value-weighted index, like those in the MSCI family of strategy indices, the number of shares outstanding is a factor. To determine the weight of each share in a value-weighted index, the share price is multiplied by the number of shares outstanding. For example, if share A has five million shares outstanding and trades at $ 15, its weight in the index is $ 750 million. If share B is traded at $ 30 but has only one million shares outstanding, its weight is $ 30 million. Thus, in a value-weighted index, action A would have more to say about how the index is evolving than action B.
In an unweighted index, all stocks have the same impact on the index, regardless of the volume or price of the stock. Any price change in the index is based on the return percentage of each component. For example, if stock A is up 30%, stock B is up 20% and stock C is up 10%, the index is up 20%, or (30 + 20 + 10) / 3 (i.e. the number of shares in the index).
Another type of weighted index is the market capitalization weighted index, where the stocks of each stock are based on the market value of the outstanding stocks. Other types of weighted indices include income weights, fundamental weights and free float adjustments. All have their positive and negative points, depending on the investor’s objectives and his knowledge of the market.