There are a number of different indices that investors look to in order to gauge investment performance. While some these may provide a good reference point they also have their limitations due to their construction. Below we look at the more common methodology of index construction.
- Market Cap Weighted: This is the most common construction for an index. The index is constructed by calculating the total value of all the stock outstanding by the various companies within the index. Weightings are calculated by taking the total value of the individual company’s shares and dividing by the total. Larger companies command a high weighting and therefore have more influence on the index’s return. The S&P 500 and the Russell 2000 are both market cap weighted indices.
- Price Weighted: A price weighted index is constructed by summing all of the stock prices of the constituents together. Similar to the market cap weighted index, a stock with a higher price will command a higher weighting than a stock with a lower price. The most common price weighted index is the Dow Jones Industrial Average (DJIA).
- Equal Weighted: While not as common as the two above, an equal weighted index weights each stock in the index the same. This allows smaller/lower priced securities to have just as much impact on performance as the larger/more expensive names. An example of an equal weighted index is the Value Line Index.
Given that indices come in a variety of flavors, it helps to know how an index is calculated so that you can understand what it measures and its limitations. For example, in 2015, a handful of stocks coined FANG (Facebook, Amazon, Netflix and Google) posted average annual returns of 83% while the S&P 500 was down 0.73% on price return basis.
