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GUEST AUTHOR BLOG by Sheldon Jacobs author of "Investing Without Wall Street: The Five Essentials of Financial Freedom."
There are several ways to construct a stock market index.
The most common way is to weight (that is to say determine its importance) the stocks in an index by market capitalization.
This method weights each stock in a portfolio based on that company’s market capitalization, which is simply the price of the stock times the number of shares outstanding.
The bigger a company’s market cap, the more it counts in the index. The S&P 500, DJ Wilshire 5000and Russell 3000are all capitalization weighted indexes.
However there are problems with capitalization weighting.
A high weighting doesn’t necessarily indicate a more profitable company or even necessarily a larger company by other measures. A company can have a big market cap simply because investors, enamored with the company, have rightly or wrongly driven up its price. Remember, price is the dynamic part of the formula. The other part of the formula, the number of shares outstanding, changes very little.
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