This topic is little more advanced than usual for this blog so try to learn the main points and don�t worry about all the details.� If you are not familiar with stock indexes then please read this post on stock market indexes first.
Market Value-Weighted Index
The most common type of index is called market value-weighted index.� What this means is that the index measures the total value of all the outstanding stock issued by the various companies in the index.� The reasoning behind a market value index such as the S&P 500*, is that companies with larger market capitalizations or value will have a larger weighting in the index and will �count more� than smaller companies.� It would not make sense for a very small company to have the same weighting in an index as a large company such as IBM.� One of the drawbacks of a market-weighted index is that sometimes one company or one type of industry can make up a very large portion of the index.� In the technology bubble of the late 90�s, the tech portion of most broad based indices became quite dominant.
Price-Weighted Index
Another less common type of index is called price-weighted.� The Dow Jones Industrial Average is the most famous example of a price-weighted index.� This means that the index is calculated using a stock price instead of the company value.� The big problem with this type of index is that a company that has a stock price of $100 will count twice as much as a company with a stock price of $50.� There is a formula used to calculate these type of indices to account for stock splits.
*In actual fact the S&P 500 index is a float-weighted index which for our purposes very similar enough to market-weighted.
