Weighting

§ 01The Rule Underneath the Number

An index is not just a list of members. Once you have decided which securities belong, you must decide how much each one matters. The weighting rule is that decision, and it shapes everything that follows: which movements drive the headline number, how often the composition drifts, and how well the index reflects what actually goes on in the market it claims to represent.

Three main rules dominate the history of index construction. The first weights by price. The second weights by market capitalisation — the total value of all shares outstanding. The third treats every member equally. Same stocks, different arithmetic, different results.

§ 02Price-Weighted: The Oldest Convention

The Dow Jones Industrial Average, computed continuously since 1896, weights each of its thirty components by the price of a single share. A stock trading at two hundred dollars influences the index twice as much as one trading at one hundred, regardless of how large the company actually is or how many shares exist in total. This felt natural in an era when a share's quoted price was the most immediately visible fact about it; it required nothing more than addition and a divisor.

The divisor — adjusted whenever a stock splits, is replaced, or pays a special dividend — is the mechanism that keeps the series continuous across corporate events. The Dow's divisor has been revised hundreds of times since 1896, and it is now well below one, meaning the average is actually a scaled sum rather than a true arithmetic mean of prices. The deeper problem is structural: a high-priced stock dominates not because the company is large but because it has never split its shares. Price weighting confuses nominal share price with economic significance.

The second weights by market capitalisation — the total value of all shares outstanding.

§ 03Capitalisation-Weighted: The Dominant Modern Form

Most major indices constructed after the 1970s weight by free-float market capitalisation — the price per share multiplied by the number of shares actually available to the public, excluding locked-up founder stakes and government holdings. This anchors the weight to something economically meaningful: a company that is twice as large, by the market's own valuation, receives twice the influence.

The practical consequence is that capitalisation-weighted indices are self-adjusting. When a stock's price rises, its weight rises automatically; no periodic rebalancing is needed to keep the weights aligned with market values. This also means that a very large company can come to represent a disproportionate share of the index. When any single member approaches or exceeds ten or fifteen percent of the total, the index starts to track that one name more than the rest of the market it claims to represent. This is not a flaw in the arithmetic; it is an accurate reflection of concentration in the underlying market. But it is worth knowing what you are measuring.

§ 04Equal-Weighted: The Deliberate Correction

An equal-weighted index assigns the same importance to every member at each rebalancing date. If the index holds one hundred stocks, each gets one percent. A very small company and a very large one speak with the same voice.

The appeal is that equal weighting gives the full population of members a hearing, not just the giants. In a capitalisation-weighted world, the smallest members are nearly inaudible. Equal weighting corrects that — but it introduces its own distortion. Because prices drift continuously, the weights immediately begin to depart from equality the moment trading opens. An equal-weighted index therefore requires periodic rebalancing, typically monthly or quarterly, to buy back into laggards and trim leaders. That mechanical activity has costs, and the rebalancing itself can move prices in thinly traded names.

§ 05Three Summaries, One Market

Lay all three indices over the same historical period and they will diverge, sometimes sharply. In a market where the very largest companies outperform, a capitalisation-weighted index rises fastest; an equal-weighted one lags. In a market where small and mid-sized companies lead, the relationship reverses. A price-weighted index follows its own private logic, shaped by which stocks happen to carry the highest nominal prices on that particular day.

None of the three is wrong. Each is the honest output of its stated rule. The question what an index is begins with — which members, and how weighted — has no single correct answer, only choices with different consequences.