Financial Education

There are several different methods for weighting the shares of each security in an index. The method chosen will result in certain biases and benefits. The three basic methods are price weighted, value weighted and equal weighted. Recently there has also been a surge in fundamentally weighted indices.

Price weighted indices are developed by adding the share price of each security and dividing the total by the number of securities in the index. The primary advantage of this method is that it is easy to calculate. It is also relatively easy to obtain historical pricing information, which allows back testing of the index. This method is equivalent to buying the same number of shares of each company in the index. For investors who follow such a strategy this method will provide a reasonable benchmark. Furthermore, since it is based on a constant number of shares it is not necessary to re-weight the index due to daily price fluctuations. Disadvantages of this weighting scheme include the fact that companies with high share prices receive higher weightings in the index for no fundamental reason. The performance of such stocks may not be representative of the performance of the overall group. Furthermore, corporate actions such as stock splits and dividends require re-weighting the index even though they do not alter the value of the securities.

Value weighted indices are based on the market capitalization of each company included in the index. In cases where certain shares (possibly resulting from family ownership) are not regularly traded the weighting may be based on the float, or traded shares. Value weighted indices returns track the return of all the publicly traded shares in the index. Advantages of this method are that it automatically adjusts for corporate actions and share price changes. It also reflects the economic changes in the overall stock market more accurately. One disadvantage is that many investors do not weight their holdings in such a manner. Furthermore, to the extent that there are inefficiencies in pricing this method assigns a higher weight to overvalued stocks and a lower weight to undervalued stocks.

Equal weighted indices invest the same dollar amount in each stock. The method is easy to initially construct and is probably more similar to the way many investors actually weight their holdings. However, daily price fluctuations can alter the weight of each security, necessitating frequent rebalancing (and associated transaction costs.) This method also assigns a higher relative weight to small companies than to larger ones.

Fundamentally weighted indices weight the securities according to fundamental factors such as sales, earnings or book value. The portfolio would only need to be rebalanced when such fundamental factors are reported (generally no more frequently than quarterly.) Such indices overweight shares of companies with high fundamental characteristics regardless of whether those characteristics translate into value. Another disadvantage is that few investors employ such a strategy, making its value as a benchmark questionable.

For more information, see all articles on: Asset Allocation, Investing in Stocks, Investment Returns, Portfolio Management, Security Selection

See also:

Commodity Benchmarks

Unweighted Securities Indexes

Approaches to Equity Investment

Price Weighted Index

Passive Investment Vehicles