Price-Weighted Index

Price-Weighted Index refers to the stock index where the member companies are allocated on the basis or in the proportion of the price per share of the respective member company prevailing at the particular point of time and helps keep track of the overall health of the economy along with its current condition.

It is a stock market Index in which companies' stocks are weighted according to their share price. This index is mostly influenced by stock, which has a higher price, and such stock receives greater weight in the index regardless of companies issuing size or number of outstanding Shares. Conversely, a stock with fewer prices has less influence on the index. In simple words, PWI is an arithmetic average of Prices of securities included in the index.

DJIA (Dow Jones Industrial Average) is one of the Price-Weighted Index in the world.

PWI Formula = Sum of Members Stock Price in Index / Number of Members in the Index.

Weight (i) = Price of Stock (i) / Sum of all the Members Prices;

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From the below index calculation, what proportion does each stock represent?

The weight of Netflix in the above index can be calculated as,

= 220/220+10.50+57

= $0.7652

The weight of Ford in the above index can be calculated as,

= 10.50/220+10.50+57

= $0.0365

Weight of Buffalo wild wing in the above index can be calculated as,

= 57/220+10.50+57

= $0.1983

Therefore, the calculation is as follows,

PWI = $220+$10.50+$57/3

PWI = $95.83

1. Dow Jones Industrial Average – Based on 30 U.S. Stocks
2. Nikkei Dow – Based on 225 Stocks

• It is easy to track the economy's overall health and the current condition of the economy.
• It allows investors to make a decision, and with the help of historical data in the index, it gives an idea to investors how the market reacted to certain situations in the past.
• One of the most important advantages of the Price-Weighted Index is its simplicity; it is easy to calculate and understand, and the weighing scheme is simple.

• If the price of small firm stock changes has the same effect on the index as price changes in large firm stock.
• A stock price in the index is not a good indicator of its true market value.
• Small companies with higher share prices may have a higher weight, and larger companies with a low share price will have Smaller weights, which will show an unclear or uncertain picture of the market.
• One of the most important disadvantages or serious biases is that the stock which nominally has a higher share price has the greatest impact on the index, and due to these, most of the stock indices don't use Price-Weighted Index.
• One of its disadvantages is that even in the event of stock splits, adjustment is made with the divisor, leading to arbitrary changes in weights.
• Due to stock splits, the price of growing firms is reduced, which gives a downgrade bias to the index.
• An index is access to a certain market, and it doesn't mean it is 100 % accurate, and several factors change the direction of the market, which sometimes do not reflect in an index.
• In this method, small and large companies have the same importance or value in the index price.

• The divisor should be adjusted whenever there are stock splits or dividends; otherwise, the index will not or would not be able to measure actual growth. So this means stock splits cause issues.
• If you look at the price-weighted index strictly, it's not an index at all; it is an average; the index is nothing but the comparison of the currently calculated average with the same base value.
• Security price or stock price alone can't communicate its true market value. It ignores the market factors of supply and demand.
• The price-weighted index is that it is biased towards high price stocks.

• PWI nowadays less common as compared to other indices, and the most common and biggest price-weighted indices are Dow Jones industrial average (DJIA) and Nikkei 225
• This technique considers only the price of each component to arrive at the final value of the index.
• A spin-off, merger, and stock split affect the structure of the Index.
• An important point to note in a price-weighted index is that the divisor changes over time to match the index's current structure.

The above description gives an insight into how the PWI provides insight into the share price of a stock in the market. An index generally measures a statistical change in the portfolio of stocks, which represents the overall market. In the year 1896 first index was created, which is known today with the name Dow Jones Industrial Average (DJIA). Nowadays, it is less popular and used than other indices due to certain limitations to the index. In addition, there are some advantages and disadvantages associated with the price-weighted index.

It is clear that it reflects changes in stock prices but does not reflect any changes in the market. For successful trading of an index, one should understand the construction of indexes. If differences and interrelationship among the indexes are understood, it is easy to understand the futures contract based on indexes. In a price-weighted index, a stock with a higher price has a higher impact on the index's performance.

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This has been a guide to the price-weighted index. Here we discuss how to calculate the Price-Weighted Index using its Formula and practical examples. You may learn more about Investment Banking from the following articles –

• Laspeyres Price Index
• Index Funds vs. Mutual Funds
• Stock Dilution
• Total Return Index Formula
• Caisse Populaire