Price-Weighted Index

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 averageArithmetic AverageThe average value represents the set of data values; the average from the whole data is calculated by adding all the set values and dividing them by the number of values. Average = (a1 + a2 + …. + an)/nread more 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

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;
Price-Weighted-Index-Formula

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For eg:
Source: Price-Weighted Index (wallstreetmojo.com)

Examples

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

So Weight of Netflix in the above index can be calculated as,

price-weighted index example 1

= 220/220+10.50+57

= $0.7652

So Weight of Ford in the above index can be calculated as,

price-weighted index example 2

= 10.50/220+10.50+57

= $0.0365

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

pwi example 3

= 57/220+10.50+57

= $0.1983

Therefore, the calculation is as follows,

pwi example 4

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

PWI = $95.83

Two Major Price-Weighted Index

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

Limitations

  • Whenever there are stock splits or Dividends, the divisor should be adjusted; otherwise, the 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 the 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 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 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 the 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 a price-weighted index, a stock with a higher price has a higher impact on the performance of the index.

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