The term index weighting refers to the approach used in the calculation of a market index. The factors used for index weighting determines how much influence an individual security has on the movement of the index over time.
Also referred to as a stock market index, an equity index is a sample of equities, or common stocks, which are used as a benchmark when comparing the performance of a smaller set of equities or an individual stock. The method used to determine how an index is calculated is important for the investor-analyst to understand, since it provides insights into the significance of the index’s movement over time. Generally, there are three ways an index can be calculated:
- Capitalization Weight: this approach uses the total market value of the security to determine its importance to, or effect on, the index. Larger companies in the index, in terms of total market capitalization, have a greater influence on the index.
- Price Weight: this approach uses the price of the stock to determine its importance to, or effect on, the index. Higher priced stocks in the index will have a greater influence on the index.
- Fundamental Weight: this approach uses a fundamental factor(s), such as revenues, book value and earnings to determine the influence an individual stock has on the index. The greater the fundamental value of the stock the greater the influence on the index.