Capitalization-weighted index

A capitalization-weighted index, or market value-weighted index, is a stock market index

with individual components weighted according to their market capitalization. A
capitalization-weighted index is computed by adding all of the market capitalizations of the
components and then dividing by an arbitrary number determined when the index comes into
existence.

For example, suppose a capitalization-weighted index ZYXWV comprises five public

companies. Company Z has a market capitalization of $50 million and 5 million shares
outstanding. Company Y has a market capitalization of $30 million and 1 million shares
outstanding. Company X has a market capitalization of $20 million and 500,000 shares
outstanding. Company W has a market capitalization of $25 million and 1 million shares
outstanding. Company V has a market capitalization of $100 million and 5 million shares
outstanding.

Each component should have a different weight based on the size of its market capitalization.
The percent each component should be weighted is calculated by dividing each individual
market capitalization by the sum of all of the index components' market capitalizations.
Company Z has a weight of 22.22%, or $50 million / $225 million. Company Y has a weight
of 13.33%, Company X has a weight of 8.9%, Company W has a weight of 11.11%, and
Company V has a weight of 44.44%.

The component with a higher market capitalization has a higher weight in a capitalization-
weighted index. The divisor given for index ZYXWV is 225,000, and the index opens with a
value of 1,000, or 225 million / 225,000.

Value of the index = market capitalization/ divisor

1000=225 million / x

Downside of Capitalization-Weighted Indexes

Certain companies can grow to the point that they take up an inordinate amount of space in
an index. As a company grows, index designers are obligated to appoint a greater percentage
of the company to the index. This can endanger a diversified index by placing too much
weight on one individual stock's performance. In addition, index funds buy more of the stock
as its market capitalization increases, meaning its share price has gone up. This goes against
the traditional investing mantra of buying at low rather than high prices. This can lead to
stock market bubbles and, subsequently, bursts. 

Price weighted index = price

capitalization-weighted index = price * no of shares outstanding = %