Index of Any Basket of Shares
Different methods are used to weight shares in a basket.
The Dow Jones Industrial Index is a price-weighted index. In a price-weighted index the prices of each component share are added up to create an average. Stocks with higher prices are weighted higher than those with lower prices, regardless of the number of shares traded or the total value of equity.
The Standard & Poor’s 500 index is an example of a capitalization-weighted index. In this weighting method, the market capitalizations of index stocks are added up to create an average. Stocks with larger market capitalizations (equity value) have higher weights than stocks with smaller market capitalizations.
Consider two stocks, the stock of Company A, which trades at a price of $30 per share and has a total market capitalization of $1 million, and the stock of Company B, which trades at a price of $10 per share and has a total market capitalization of $4 million. A price-weighted index of these two stocks would weight the stock of Company A as 75%, since it is $30 out of the $40 sum of their prices. A market-weighted index of these two stocks would weight the stock of Company A as 20%, since it is $1 million out of the $5 million sum of their market capitalizations.
We return to the Dow Jones components table. The value of the index was 11,659.9. . When the change in the index is listed in percentages, the change between any two dates reflects the average profit (loss) in terms of percentages that every USD invested in the basket produced.
In the Dow Jones components table, every dollar that was in the basket on August 15, 2008 (at the end of the day) produced 0.04% on the next day because the index also rose by 0.04%.
Changes in the weight of the companies in the basket
The market value of each company changes every day, as a result of the change in the price of its share. When the company’s share price rises by less than the rise in the value of the basket, then the company’s weight in the basket decreases.
By the same token, a company’s weight also changes when the price of its shares falls. If its share price falls by more than the price of the basket, its weight decreases, and if its share price falls by less than the price of the basket, its weight increases.