Price Weighting [CapiPedia]

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======Price Weighting======
Price weighting is a method for constructing a [[stock market index]] where each component stock's influence on the index is determined by its price per share. In a price-weighted index, a stock with a high price carries more weight and has a greater impact on the index's movement than a stock with a low price, regardless of the company's actual size, number of shares outstanding, or overall market value. This is one of the simplest, and oldest, methods for calculating an index. Imagine a tug-of-war where the player who happens to have the highest number on their jersey pulls the hardest, not the strongest or heaviest player. That's price weighting in a nutshell. It's a straightforward calculation, but as we'll see, its simplicity comes with some significant quirks that investors need to understand.
===== How It Works: The Simple (But Flawed) Math =====
The calculation for a price-weighted index is beautifully simple, which explains its popularity in the pre-computer era. In its most basic form, you just add up the share prices of all the stocks in the index and divide the total by the number of stocks.
However, to maintain consistency over time, the calculation uses a special number called a [[divisor]]. The formula is:
//Index Value = (Sum of the prices of all component stocks) / Divisor//
The [[divisor]] starts as the number of stocks in the index but is adjusted to prevent events like [[stock split]]s, special dividends, or changes in the index's components from creating a misleading jump or fall in the index's value. For example, if a $100 stock splits 2-for-1 and its price becomes $50, the company's value hasn't changed. The divisor would be adjusted downwards to ensure the index value remains stable right after the split, reflecting the new, lower price.
==== A Simple Example ====
Let's create the "Capipedia 3 Index" with three fictional companies:
  * Company A: $120 per share
  * Company B: $50 per share
  * Company C: $10 per share
The initial index value would be ($120 + $50 + $10) / 3 = $180 / 3 = **60**.
Notice that a 10% move in Company A's stock (a $12 change) has a much larger effect on the index than a 10% move in Company C's stock (a $1 change).
===== The Good, The Bad, and The Quirky =====
While historically important, price weighting has some distinct characteristics that modern investors, especially value investors, should view with a critical eye.
==== The Good: Simplicity Itself ====
The main advantage of a price-weighted index is its simplicity. It's easy to calculate and understand on a basic level. It gives a raw, unadorned average of the nominal share prices of a group of companies, which was a practical benefit when all calculations were done by hand.
==== The Bad and The Quirky: The Tail Wagging the Dog ====
The primary flaw of price weighting is that a company's stock price is a largely arbitrary number. A company can have a high stock price simply because it has never split its stock, not because it is a larger or more successful business than a peer with a lower stock price.
This leads to several distortions:
  * **Price, Not Value:** The index gives the most influence to the company with the highest //price//, not the highest [[market capitalization]] or fundamental value. A small company with a $500 stock price would have more sway than a corporate giant with a $50 stock price.
  * **The Stock Split Anomaly:** When a company in a price-weighted index executes a stock split, its share price drops, and so does its influence on the index. The company's underlying value remains the same, but its ability to move the index is artificially reduced. This means corporate accounting decisions, not economic reality, can alter the index's composition and behavior.
===== Famous Examples: The Dow and The Nikkei =====
Despite its flaws, two of the world's most frequently cited indexes are price-weighted:
  * **The [[Dow Jones Industrial Average]] (DJIA):** Often just called "The Dow," this is the most famous price-weighted index. It tracks 30 large, publicly-owned blue-chip companies in the United States. While iconic, it's a very narrow snapshot of the massive U.S. economy.
  * **The [[Nikkei 225]]:** This is the leading and most respected index of Japanese stocks, trading on the Tokyo Stock Exchange. Like the Dow, its movements are dictated by the highest-priced stocks in its basket of 225 companies.
===== A Value Investor's Takeaway =====
For a serious investor practicing [[value investing]], a price-weighted index is more of a historical curiosity and media headline-grabber than a useful analytical tool. The core philosophy of value investing is to distinguish between a company's //price// and its underlying //intrinsic value//. Price weighting completely ignores this distinction, focusing only on the arbitrary price tag of a single share.
While you'll hear about the Dow's daily movements on the news, remember that its performance is skewed by its highest-priced members. For a more accurate picture of broad market performance, investors are better served by looking at a [[market-cap weighting|market-capitalization-weighted]] index like the [[S&P 500]]. Better still, a value investor should spend their time analyzing individual businesses, not getting distracted by the peculiar dance of a price-weighted index.