Price-weighted vs market cap-weighted indices: What's the difference?

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Choosing the right indices as market benchmarks is crucial for traders. But do you know the key differences between price-weighted and market-cap weighted indices?

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In financial markets, indices serve as benchmarks that capture the performance of a basket of stocks. Among these, price-weighted and market capitalisation-weighted (market cap-weighted) indices stand out as the most prevalent methods of constructing stock indices. Understanding the distinctions between these two methods is essential for traders and investors, as the choice of index construction can significantly influence the perceived performance of the market. 

What is a price-weighted index?

Imagine attending a potluck dinner where the decision-making power of each guest is based on the price of the dish they bring. Those who bring more expensive dishes have a greater say. Similarly, in a price-weighted index, companies with higher stock prices have more influence on the index's overall performance. It's like saying a 100 USD bottle of wine impacts the dinner's menu more than a 10 USD salad.

Price-weighted indices like the Dow Jones Industrial Average (DJIA) assign weights based on the stock prices of the companies. In this structure, companies with higher stock prices disproportionately influence the index, irrespective of their overall market size. This method is somewhat intuitive but can be misleading as a company's stock price is not always indicative of its total economic size or health. For example:

• Boeing's influence on the Dow Jones Industrial Average, DJIA (2019-2020): In the period leading up to and during the early stages of the Covid-19 pandemic, Boeing, with its high stock price, held significant sway over the DJIA. Despite Boeing facing operational challenges and a decline in demand due to the pandemic, its high stock price meant that its performance had a disproportionate impact on the DJIA, sometimes overshadowing broader market trends.

• Apple's stock split and impact on the Dow Jones Industrial Average, DJIA (2020): Apple's 4-for-1 stock split in August 2020 serves as another example. Prior to the split, Apple had one of the highest stock prices in the DJIA, giving it substantial influence over the index. However, post-split, its reduced stock price lessened its impact on the DJIA. This change did not reflect any alteration in Apple's fundamental value or market cap but was purely a result of the mechanical adjustment in its stock price.

The two examples above illustrate the primary critique of price-weighted indices: that they can be skewed by the stock prices of their constituents. This can lead to distortions in perceived market performance, particularly if the movements of high-priced stocks are not aligned with broader market trends.

What is a market cap-weighted index?

Now, consider a different scenario where influence at a community meeting is based on the total wealth of each participant. Here, wealthier individuals have a bigger impact on decisions. In market cap-weighted indices, companies are weighted based on their total market value, calculated by multiplying the stock price by the number of shares they have outstanding. A billion-dollar company, therefore, has more sway than a million-dollar company.

Market cap-weighted indices weigh their constituent stocks based on their market capitalisation – the total market value of a company's outstanding shares. In this approach, companies with higher market values have a greater impact on the index's overall performance. This method is lauded for its reflection of the market's actual size and the relative economic impact of its constituents.

We can look at two real-life examples below to further understand this.

1. S&P 500:

The S&P 500, one of the most widely followed stock indices globally, is a market cap-weighted index consisting of 500 large-cap US stocks. Its structure means that companies with higher market capitalisations have a more significant impact on the index's performance. 

For instance, tech giants like Apple, Microsoft, Amazon, and Alphabet (Google) had substantial weights in the index. When these companies perform well, their growth can disproportionately drive the S&P 500's overall performance, reflecting the alignment with market value dynamics. Conversely, if these tech giants face a downturn, their large weights can drag the index down more than smaller constituents would. 

During the period following the Covid-19 market crash in early 2020, the rapid recovery and growth of tech giants like Apple and Microsoft, spurred by the pandemic's push towards digital transformation, significantly aided the S&P 500's rebound from its initial sharp decline.

2. NASDAQ Composite:

Similarly, the NASDAQ Composite, known for its tech-heavy composition, is another market cap-weighted index. It includes over 3,000 stocks, with a significant concentration in technology and internet-related companies. 

Companies like Apple, Microsoft, and Amazon, due to their enormous market caps, hold considerable sway over the index's movements. The NASDAQ's performance, especially during tech booms or downturns, can be largely attributed to the movements of its largest constituents. This makes the NASDAQ a prime example of both the advantages of market cap weighting in reflecting market trends in specific sectors and the risks of concentration where a few large players dominate.

The examples above illustrate that the key advantage of market cap weighting is its alignment with the overall market's value dynamics. As companies grow or shrink in value, their influence on the index adjusts correspondingly, offering a real-time mirror of market movements. 

However, this approach can lead to concentration risk. If these top companies, which command significant portions of the index, were to experience a downturn, their impact would be more pronounced on the index than that of smaller companies. 

Pros and cons of price-weighted and market-cap weighted indices

When choosing an index to track the market, understanding the fundamental differences between price-weighted and market cap-weighted methodologies is crucial. Both have their own merits and drawbacks, making the choice dependent on your trading goals and risk tolerance.

Ultimately, the choice between price-weighted and market cap-weighted indices depends on your trading goals and risk tolerance. If you want a simple, intuitive measure of large, established companies, a price-weighted index might be suitable. However, if you prioritise a more accurate reflection of the overall market's performance and are comfortable with some concentration risk, a market cap-weighted index might be a better choice.

Regardless of your choice, remember that no single index provides a perfect picture of the entire market. Diversification across different indices and asset classes is always recommended for a well-rounded investment portfolio.

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