Alternatives

There are other ways to create a stock market index. With an equal weight index, each stock makes up the same percentage of the index by value, so the index includes different quantities of each stock. With a capitalization weighted index, or a market value weighted index, the number of shares available for investors to purchase times the price of each share, or its capitalization, determines its weight. The company's percentage of the index by value is its capitalization divided by the capitalization of every firm in the index.

Movement

A price weighted index is heavily influenced by stocks that have a large share value. If company A's stock increases from $100 to $150, company B's stock falls from $50 to $40, and company C's stock falls from $30 to $20, the value of the index increases even though the share price dropped for most of the companies on the index.

Perspective

An equal weight index reflects changes in a market sector better than a price weighted index. If a company with valuable shares fires its CEO, purchases another company, or issues a large quantity of shares, the index may fluctuate sharply, even though the event may not greatly affect any of the other companies in the sector. With an equal weight index, the fluctuation is much smaller.

Number of Shares

A change in the value of a smaller company can produce a large change in a price weighted index if the smaller company has a high share value. The capitalization weighted index solves this problem by including the number of outstanding shares in the calculation, because a smaller company with high priced stock will have few outstanding shares compared to a larger company with cheaper stock.

Significance

Although the price weighted index has disadvantages compared to the other two methods, it is easiest to calculate. According to Standard & Poor's, the Dow Jones Industrial Average, a major index, uses price weighting because the index was established in 1890, so computer technology that could perform rapid calculations to produce the other indexes wasn't available. Indexes established more recently usually use capitalization weighting, including the NASDAQ and the S&P 500.