Lesson 3 of 7 · All lessons in this module
- What an index is: value, price return and total returnVideo lesson
- Building an index: target market, constituents and weighting
- Price-weighted and equal-weighted indexesVideo lesson
- Market-cap, float-adjusted and fundamental weightingVideo lesson
- Rebalancing, reconstitution and what indexes are used for
- Types of equity indexes
- Fixed-income, commodity, real estate and hedge fund indexes
Lesson 3 of 7 · 14 min
Price-weighted and equal-weighted indexes
A price-weighted index lets the highest-priced share dominate and needs a new divisor after every split; an equal-weighted index gives every stock the same slice, which overweights small companies and drifts away from equal weights as soon as prices move.
In short
- Price weighting: weight = price ÷ sum of prices. Index value = sum of prices ÷ divisor; the divisor often starts as the number of constituents.
- A stock split in one constituent changes every weight in a price-weighted index, so the divisor is reset: new divisor = sum of post-split prices ÷ pre-split index value.
- Price weighting is simple but gives arbitrary weights driven by share price levels.
- Equal weighting: each stock gets 1/N of the index value at inception; the index return is the simple average of the constituents' returns.
- Equal weighting is simple, but it underrepresents large and overrepresents small companies, and needs frequent rebalancing because weights drift as prices change.
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