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Index Creation Methods

Index construction can be done in different ways and it substantially influences the returns on a particular investment. We can identify three main methods:

1) Market Value-Weighted Method

This method represents the most widely used technique for creating an index. In the market value-weighted method each stock is assigned an assessment that is proportional to its capitalization on the market. To get a clearer grasp of the concept, imagine that company X is worth $500 million, whereas company Y is worth $250 million. Therefore, company X will be given twice the weight of company Y. An index that is created by this method gives a more thorough grasp of the economic activity. Additionally, more systematic information on the changes of the valuations of the companies within a particular index is given, which provides for higher transparency. These statements can be backed up by the fact that the assignment of higher weightings to larger companies reflects their greater revenues and profits. This in turn implies the fact that a change in such a company can lead to far more substantial effects on the overall economic activity than a change in a smaller company.

Indexes that are constructed by the market value-weighted method: Nasdaq Composite Index, Wilshire 5000, London FTSE, and etc.

2) Price Weighted Method

In the price weighted method, each stock is assigned an assessment that is proportional to its market price. This method is characterized by an important drawback, namely that it outweighs the performance of companies, whose stocks have been listed with higher prices. A logical explanation of this drawback could be the fact that at the time of creation of this method the tendency was toward fixed-income financial tools and the emergence of stock splits, takeovers, run-offs, mergers and acquisitions was not expected. As a result, the estimation was based on the average of the 12 stocks in the index.

The indicators for large companies and higher market caps were the higher prices. Even though this is not the case today, this method is still widely applied. An example for price weighted index is DJIA (Dow Jones Industrial Average).

3) Equal Weighted Method

In this method of evaluation, each stock in the index is equally weighted. As a result small companies are given the same treatment as large ones. On the other hand, large companies' better performance is cancelled out by the weak performance of smaller companies. This method of weighting overemphasizes to a great extent the importance of smaller companies, since their presence is far more prevalent.

As a rule, the change in prices leads to a change in the weighting of stocks, where the market value-weighted and price-weighted method of index creation has been applied. On the other hand, this price change has no influence at all on the weightings of the stocks in the equally-weighted index, since this index always remains one and the same.

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