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Topic Title: price weighted Index Series - any advantage
Created On Sun Sep 07, 03 02:57 PM

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drona
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Sun Sep 07, 03 02:57 PM

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Indices like Dow and Nikkei are price weighted. The prices and hence the weightings are high
for the top 5-10 stocks ( at least in the DOW). What does an Index calc using this methodology
really tell you.

Is it possible to test if the Index levels are largely due to these big names. I can create an equal
weighted series, snd see if it performs the same way, is this the right way to do it.

regards

FDAXHunter
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Sun Sep 07, 03 07:29 PM

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You can easily see a price weighted index has weights that are dependent on the most expensive stocks.

In a capitalization weighted index:

(Q(1)*P(1) + Q(2)*P(2) +... + Q(n)*P(n))/Divisor

Q(n): weight of company n, usually number of shares outstanding, or free-float.
P(n): Price of the shares of n.

So, the stock with the largest Q will have the largest impact when it's price moves.

In a price weighted index:

(P(1)+P(2)+...+P(n))/Divisor

So, you know that the stock with the highest price moves, it will affect the index mosts, because, say all stocks move up 1%, that means that a stock with a price of 1000 will affect the index much more (10/Divisor) than a stock with a price of 20 (0.2/Divisor). It tells you exactly that... the higher the price of a stock, the more it affects the index.

There isn't really much of a sensible interpretation, as it is pretty meaningless to look at a price weighted index for investments. As you probably know, almost all indices are capitalization (or free-float) weighted.

If you wanted to see the effect of a single name, just subsract the single name out of the index.

Hope this helps.

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Chiral3, kr, Nonius, Newton and FDAXHunter on a little boat drifting aimlessly on Hell's vast lake of burning sulphur.

drona
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Mon Sep 08, 03 07:49 PM

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thanks, but I thought quite a few people look at the DOW as an indicato for the overall health of the stock market.

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Beans
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Tue Sep 09, 03 09:18 AM

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Yes the DOW is extremelly important to people and is used as guage of when to enter into the mkt etc. But there is no good theoretical reason for a price weighted index to be so useful.

FDAXHunter
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Tue Sep 09, 03 09:55 AM

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I never look at the DJIA.

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Chiral3, kr, Nonius, Newton and FDAXHunter on a little boat drifting aimlessly on Hell's vast lake of burning sulphur.

MikeM
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Wed Sep 10, 03 10:21 PM

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I think the Dow is popular for historical reasons. I believe it was one of the first market indexes in the US (possibly in the world). ...It surely predates the S&P 500 and NADAQ.

BTW, the S&P 500 tend to be the index of choice for economists looking at the US. (Wilshire indexes technically give a broader view, but teh S&P gets most of it).

Aaron
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Fri Sep 12, 03 12:09 AM

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The DJIA is the most popular and worst major index. It's not just the price weighting, it has other computational defects as well.

Price weighting was invented when indices were computed by hand. It's easy to add up 10 stock prices and divide by 10. It's harder to multiply each one by a weighting factor. Also, they're easier to explain, since the index value can be compared to individual stock prices. 100 years later when the divisor has gone from 30 to 0.007, you have lost that advantage.

Another reason price weighting made sense in the past is that stock had a closer relation to its par value. Today we expect bonds to be stated in $100 denomination and most preferred stock is issued in $25 shares. So I can average a bunch of bond prices or preferred stock prices and get a meaningful answer. But common stock has lost any relation to a standard price.

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Aaron Brown

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