price-weighted index

An index where member companies are weighted by their share price rather than their total market value.

A price-weighted index is a stock index where the constituent companies are weighted solely by their individual share prices rather than their total market capitalization or outstanding shares. In this methodology, a stock trading at $100 per share exerts ten times more influence on the index's movement than a stock trading at $10 per share, regardless of whether the $10 company is actually much larger in terms of total market value. To calculate the index value, the share prices of all member stocks are added together and then divided by a specific number known as the index divisor. The divisor is a dynamic figure that is adjusted whenever a member company undergoes a stock split, issues a special dividend, or is replaced by another company. This adjustment ensures that corporate actions do not artificially cause sudden jumps or drops in the index's overall value. Investors monitor price-weighted indexes because they include some of the most famous benchmarks in financial history, such as the Dow Jones Industrial Average. However, the methodology has significant pitfalls. Because weighting is tied to share price, a high-priced stock experiencing a minor percentage move can heavily distort the index, overshadowing a massive percentage move in a lower-priced stock of a much larger company. Consequently, stock splits by member firms can dramatically alter their influence on the index overnight.

Consider a price-weighted index composed of only three stocks: Stock A at $150, Stock B at $30, and Stock C at $20. The sum of the prices is $200 ($150 + $30 + $20). Assuming an initial divisor of 3, the index value is 200 / 3 = 66.67. If Stock A rises by 10% (+$15) to $165, and Stock B falls by 50% (-$15) to $15, the sum of the prices remains $200, and the index remains unchanged at 66.67, despite the massive percentage loss in Stock B.