What it means
Most modern indices weight companies by their market value, so bigger companies move the index more. A price-weighted index ignores size and looks only at the price per share.
A well-known example is the Dow Jones Industrial Average, which tracks a small group of large US companies. The index is calculated by adding up the share prices of all the members and dividing by the divisor.
At the start the divisor might be the number of stocks, but over time it is adjusted so the index does not jump when a company splits its shares or when the list of members changes. Without that adjustment, a stock split would artificially cut the index.
The result is a quirk that managers and investors should know about. A move of $3 in a $30 stock and a $3 move in a $90 stock have exactly the same effect on the index, even though one is a 10% change and the other 3.33%.
A high-priced stock can dominate the index purely because it has not split its shares. Price weighting is simple to calculate and easy to explain, which is one reason older indices use it.
The drawback is that it does not reflect the economic weight of the companies, so it can be a poor guide to how the overall market is performing. A very large company with a low share price can have a small effect.
The weighting also creates incentives that managers sometimes notice. A company with a very high share price carries extra influence on the headline number, so its moves are widely reported even when the wider economy is quiet.
Others may choose splits partly to make shares more accessible to ordinary investors. When using an index as a benchmark for performance, it helps to know how it is weighted.
A fund compared with a price-weighted index is being measured against a yardstick that behaves differently from one weighted by market value.
In practice
Real-world examples.
Example
An investor reads that a famous price-weighted index rose 100 points in a day. He checks which high-priced shares moved, because a few expensive stocks can account for most of the change.
Example
A portfolio manager benchmarks her fund against a price-weighted index. She realises the fund holds several large companies with low share prices that barely register in the index, so her tracking error looks bigger than it should.
Example
A company decides to split its shares to make them more affordable. The index provider adjusts the divisor so the index does not fall, but the company's influence on the index drops because its price is now lower.
Formula
Calculation
Price-weighted index = Sum of the share prices of all members / Divisor.
An index has three stocks priced at $90, $60 and $30. The sum is $90 + $60 + $30 = $180. With a divisor of 3, the index is $180 / 3 = 60.
Now the $90 stock splits two for one, so its price falls to $45. The new sum is $45 + $60 + $30 = $135. To keep the index at 60, the divisor must change to $135 / 60 = 2.25. Check: $135 / 2.25 = 60.
After the split, if the $30 stock rises by $3 the index rises by $3 / 2.25 = 1.33 points, and if the $45 stock rises by $3 it moves by the same 1.33 points, even though the second is a smaller percentage change.Case study
Seen in the real world.
Northgate Exchange is a fictional stock market with a price-weighted index of five companies. In an illustrative week, a manufacturer worth a fraction of the others but trading at $400 per share rose by $20, and the index jumped.
Financial news reported a strong market, but a closer look showed the other four stocks were broadly flat. The fictional analyst at a local bank pointed out that the high-priced manufacturer carried a disproportionate weight because of its share price.
She recommended that clients also track a market-value weighted index to gauge the economy more accurately. The case shows why knowing the weighting method prevents false conclusions about overall market direction.
Watch out
Common mistakes.
- Assuming bigger companies always have a larger influence, when in a price-weighted index only the share price matters.
- Forgetting that stock splits change the divisor and the weights, which can alter how each member affects the index.
- Treating a price-weighted index as a full measure of the market when it covers only a small group of stocks.
Questions
People also ask.
How is it different from a market-capitalisation weighted index?
A market-capitalisation index weights by company value, while a price-weighted index weights by share price alone.
What is the divisor for?
It is an adjustment number that keeps the index continuous when shares split or members change.
Why do some indices still use price weighting?
It is simple to calculate and has a long history, and changing the method would break comparisons with past data.
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