An index is a basket of stocks. The way the weights are assigned decides how much of each stock is in the basket. Two indexes can have the stocks and still act very differently because the way the weights are calculated is different.
The two main ways to calculate weights are price weighting and market capitalisation weighting. Many Indian investors use market-cap weighting without knowing it. Price weighting is more common in the US with the Dow Jones Industrial Average.
what a market cap weighted index is
A market-cap weighted index gives weight based on the value of the company. The weight is calculated by multiplying the share price by the number of shares that’re available.
If a company has a market value of ₹10 lakh crore and the total index has a market value of ₹100 lakh crore the company gets 10% of the weight. The actual share price doesn’t matter. A company with a ₹10 share price and 100 crore shares has the market value as a company with a ₹1,000 share price and 1 crore shares.
The Nifty 50 and the S&P 500 use this method. The biggest companies have the weight. This means the index moves based on the companies not on how many companies are going up or down.
What a price weighted index is
A price-weighted index gives weight based on the share price of the company. The higher the share price, the the weight.
In a price-weighted index with three stocks priced at ₹100 ₹50 and ₹10 the weight is based on the prices. The ₹100 stock has the influence on the index and the ₹10 stock has the least.
The Dow Jones Industrial Average uses this method. It holds 30 US companies. A stock priced at $500 has than double the influence of a stock priced at $200 even if the $200 stock is a bigger company in terms of total value.
Why price weighting is unusual
Price weighting leads to some results.
A high share price does not mean a company. A company can have a $1,000 share price and a market value of $5 billion while another company can have a $50 share price and a market value of $500 billion. The first company gets weight in a price-weighted index even though it is much smaller.
Stock splits change the index. When a company splits its shares the price drops and the weight in a price-weighted index also drops. The company itself hasn’t changed,. The index weight has.
Price weighting favors stocks. A company that has a rising share price gets weight in the index. This is the opposite of market-cap weighting, where the weight follows the value of the business.
The Dow Jones partly fixes this by using a divisor that adjusts for stock splits and other changes.. The basic idea remains. The share price controls the weight.
How market cap weighting differs
Market-cap weighting is more logical. The bigger the company, the weight it gets. The index shows the value of the companies it includes.
A stock split does not change the weight in a market-cap weighted index. The price drops,. The number of shares increases so the market value stays the same. The weight stays the same.
When a companys share price rises, its market value also. Its weight in the index increases. This reflects the markets view of the company, not the price of one share.
What it means for investors
Most Indian index funds follow market-cap weighted indexes. The Nifty 50 Nifty 100 Nifty Midcap 150 and Nifty 500 are all market-cap weighted. An investor who buys a 50 index fund is buying the 50 biggest companies, weighted by their size.
Price-weighted indexes are rare in India. The Dow Jones is the example globally and Indian investors only see it if they buy a US ETF that tracks it.
For an investor comparing indexes the weighting method is important. A price-weighted index and a market-cap weighted index can act differently even if they have the same stocks. The market-cap index is driven by the companies. The price-weighted index is driven by the expensive stocks.
The alternative weighting methods
ways to assign weights exist.
Equal weighting. Every stock gets the weight. The Nifty 50 Equal Weight index gives each of the 50 stocks a 2% weight. This lowers the concentration. Requires regular rebalancing.
Fundamental weighting. Weights are based on numbers like sales, book value or dividends not on price or market value.
Factor weighting. Weights are based on traits like risk, strong performance or value.
Each method creates an index with different returns and different risks.
What retail investors should take from this
The way the index is weighted affects how it behaves. A market-cap weighted index is driven by the companies. A price-weighted index is driven by the expensive stocks.
Indian indexes use market-cap weighting. The price-weighted method is mostly seen in the US with the Dow Jones.
For an investor who buys an index fund the weighting method should be part of the decision. Two funds that seem to track the industry or theme can act very differently if they use different weighting methods.
FAQs
1. What is the difference between price-weighted and market cap weighted indexes?
A price-weighted index gives weight based on the share price. A market cap weighted index gives weight based on the value of the company. The share price is not important in a market cap index. The size of the company matters.
2. Which indexes in India are price-weighted?
Almost none. The major Indian indexes, including the Nifty 50 Nifty 100 and Nifty 500 are all market-cap weighted. Price-weighted indexes are mostly in the US with the Dow Jones Industrial Average being the example.
3. Why does a stock split affect a price-weighted index?
When a company splits its shares the price drops. In a price-weighted index a lower price means a weight. The company hasn’t changed,. The index weight has.
4. Does a stock split affect a market-cap weighted index?
No. A stock split lowers the share price. Increases the number of shares so the market value stays the same. The weight, in a market-cap weighted index doesn’t change.
5. What is an equal-weight index?
An equal-weight index gives each stock the weight no matter the price or market value. The Nifty 50 Equal Weight index gives each of the 50 stocks a 2% weight. It reduces the chance of one company being too big. Requires regular balancing.
