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.
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.