Usually, when you see the term "index" used to refer to investments and mutual funds, it means a market capitalization-weighted index. The weight of each holding is determined by the total value of the outstanding stock of the company. However, you can also construct an index that gives each holding an equal weighting, or you can weight the index by stock price. One problem with this approach is that the index will be less representative of the economic performance of the sector the index measures, because a very small company may have a higher price per share than a huge multinational conglomerate. The index could also be substantially affected by artificial considerations, such as a stock split, where a company cuts its share prices in half and doubles the number of shares.
1. Determine the stocks or other securities that will make up your index. These securities should have something in common, such that they are representative of a given market, industry or asset class. You may use the stocks in an existing index, such as the Dow Jones Industrial Average or Standard & Poor's 500 index of large U.S. corporations.
2. Add together the total price of each security.
3. Divide the total value of all the prices by a "divisor." This helps reduce the value of the index to an easily comprehensible number. It does not matter what number you use, as long as your methodology is consistent because you use the same divisor each time you calculate the value of the index. However, the Dow Jones Industrial Average initially divided the total value of all the prices of component stocks by the number of stocks in the index.
4. Adjust the divisor when a company issues a dividend or does a stock split. This will help prevent the index from being manipulated or distorted by component companies manipulating their stock price. When a company does a stock split, for example, it cuts its share price in half, but the value of the company is unaffected. When this occurs, you must lower the divisor to cancel out the effects of the stock split.
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