What is Price-Weighted Index?
Price-Weighted Index refers to the stock index where the member companies are allocated the 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 in keeping the track of the overall health of 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. 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.
Price-Weighted Index Formula
Examples
From the below index calculation, what proportion does each stock represent?
So Weight of Netflix in the above index can be calculated as,
= 220/220+10.50+57
= $0.7652
So Weight of Ford in the above index can be calculated as,
= 10.50/220+10.50+57
= $0.0365
So 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
Two Major Price-Weighted Index
- Dow Jones Industrial Average – Based on 30 U.S. Stocks
- Nikkei Dow – Based on 225 Stocks
Advantages
- It is easy to track the overall health of the economy 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, understand and the weighing scheme is simple to understand.
Disadvantages
- If the price of small firm stock changes has the same effect on 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 price may have higher weight and larger companies with a low share price will have Smaller weight and which will show an unclear or uncertain picture of the market.
- One of the most important disadvantages or serious bias of it 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 the disadvantages of it is that even in the event of stock splits adjustment is done with divisor and it leads to arbitrary changes in weights.
- Due to stock splits price of growing firms reduced which gives downgrade bias to index.
- An index is just am access to a certain market and it doesn’t mean it is 100 % accurate and there is a number of factors that 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.
Limitations
- Whenever there are stock splits or Dividend, the divisor should be adjusted otherwise index will not or would not able to measure actual growth. So this means stock splits cause issues.
- If you look at Price-Weighted Index strictly it’s not an index at all it is an average, the index is nothing but the comparison of currently calculated average with the same base value.
- Security price or stock price alone can’t communicate its true market value. It ignores market factors of supply and demand.
- The problem with the price-weighted index is that it is biased towards high price stock.
Important Points
- PWI nowadays less common as compared to other indices and 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 arrived 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 that divisor change over time to match with the current structure of the index.
Conclusion
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 as compared to other indices due to certain limitations to index. There are some advantages and disadvantages associated with the price-weighted index.
It is clear that it reflects changes in stock prices but did not reflect any changes in the market. For successful trading of an index, one should have an understanding of the construction of indexes and if differences and interrelationship among the indexes are understood then it is easy to understand the futures contract that is based on indexes. In price-weighted index stock with higher price has a higher impact on the performance of the index.
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