Portfolio Formation Strategies - The Price - Weighted Portfolio
Price-weighted-index

Overview

There are three types of weighted indexes in the investment world, and the price-weighted index is just one of those. A stock index where each stock affects the index as per the set price per share is known as the price weighted portfolio.

Basically, the value of the index will be generated when the prices of each of the securities in the index are added and then divided by the total number of stocks in the given company. As such, securities with a higher price will get more weight; hence have greater impact on the performance of the indices than those with a lower price.

As the name may suggest, this is a category of stock market index that is used by traders to assess the value of a given group of stocks. In the priced weighted trading portfolio, the higher the price of shares of a given stock, the much weight the stock is given. It is therefore correct to say that in a price-weighted portfolio, the overall value of any given group of stock is significantly affected by the stocks that have the greatest share values and is less affected by those with noticeably lower values.

In other words, the index trading price is determined by the trading prices of the individual stocks that make up the index basket (basically referred to as the components). For example, if some securities rise from $100 to $110, it has the potential to move the index more than security that goes from $30 to $45, despite the fact that the percentage move is much greater for the lowly priced stock that moved from $30 to $45.

The price-weighted portfolio is commonly used in most of the renowned stock market indexes, most notably the Dow Jones Utility Average and the Dow Jones Industrial Average in the US. The main thing to keep in mind when looking at this portfolio is the share value. Despite how big a company is or the number of outstanding shares it has, the share value is the main determinant factor.

In other words, if company X has 5,000 shares each worth $80 and company Y has 50,000 shares each worth $20; despite the fact that company Y is worth a lot more based on the overall market value since it has a lot more shares, company X will be weighted higher when using the price-weighted portfolio since its price per share is much higher.

The price-weighted portfolio vs. market-value weighted portfolio

Because of this weight, it means that the fluctuation in share value will affect the average differently for varying securities. Take the example above, company X’s stock would have up to 4 times the impact on the overall value of the average since its share price is 4 times that of company Y. This scenario is in huge contrast to the other common strategy – market-value weighted portfolio, where the overall market value of the shares of a given company is what will determine the average value of the given index.

Basically, the market value is the number of company shares multiplied by the share price. Still in the above example, company Y will have a significant influence than company X because it has a higher overall market value, if the market-value weighted portfolio was used. Market index are useful in showing investors the direction stocks in a given area of business or country are moving, thus helping them make informed decision on whether they should sell or retain their securities.

Price-weighted indices calculations

You should know by now that the stock indices play significant roles in the global investment arena. Generally, they will serve as points of reference of equity markets, hence are a good and reliable indicator of investor sentiment and economic situation of any given company. Basically, these indices are used in analysis and decision making. Among the above-mentioned three types of stock indices, the price-weighted index is the simplest and happens to be the oldest of all.

Biases of price-weighted portfolio

The major bias of this type of portfolio and the main reason why most indices do not use this portfolio today is because the securities with supposedly high share prices will have the most impact.

The index divisor

Another thing worth mentioning in relation to the price-weighted portfolio is the index divisor, which basically represents the denominator in a complex or technical stock formula. It is commonly applicable in price weighted index, although sometimes it can be used with other stock indices as well. Basically, most national stock indices will use an index advisor to calculate the total value reported for a given group of securities.

A perfect example is the Dow Jones Industrial Average in the US which takes the value of each company listed within the Dow and divides it by the Dow Jones Industrial Average index advisor. Note that this index divisor is constantly changing hence comes in handy in making adjustments to allow stakeholders and shareholders have similar information over a given period of time for a given stock index.

Basically, the calculations will allow shareholders to re-examine the whole index when a company within the stipulated index issues more securities. When this happens, any further securities offering will come with a title such as a second or third offering. The reason why most companies will have additional stock offering in future after an IPO is because of the increased demand, mostly due to the additional need for more capital to run the company. As such, for a price-weighted portfolio to provide the comparable data in a given trend, it is expected that the index divisor will equally change.

Conclusion

The final thing that should be mentioned is that while any future stick offerings will definitely change the index divisor, all the other items will remain the same, for instance, the dividends a company issues will not change the index advisor, and so are stock splits. They will not have an effect on the divisor which will be used to calculate the price-weighted portfolio figure.



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