Price-Weighted Index

Definition

A Price-Weighted Index is a stock index in which each member company's weight is determined by its share price. * Simply put, stocks with higher prices have a greater influence on the index's performance than those with lower prices. * Major Examples: Dow Jones Industrial Average (DJIA), Nikkei 225.

The Logic (Price is Power)

In this system, the "size" of the company (Market Cap) is irrelevant. * Scenario: * Stock X: Price \$10 (Huge Market Cap) * Stock Y: Price \$200 (Small Market Cap) * Impact: A 1% move in Stock Y (\$2 change) will move the index 20 times more than a 1% move in Stock X (\$0.10 change). * This creates a situation where a smaller company can dominate the index simply because it hasn't split its stock.

The Flaw: Stock Splits

This methodology is highly sensitive to Stock Splits. * If a company executes a 10-for-1 stock split, its share price drops by 90%. * In a price-weighted index, this company's influence on the index immediately drops by 90%, even though the company's fundamental value hasn't changed.

The Fix: The Divisor

To prevent the index from crashing artificially due to stock splits or dividends, the index committee uses a mathematical adjustment called the "Divisor." * Instead of dividing the sum of prices by the number of stocks (e.g., 30), they divide it by the "Divisor." * When a stock splits, the Divisor is lowered to keep the index level constant.