Stock Indexes are used to track the performance of stocks across various markets and sectors. Different indexes reflect different aspects of economic health, and are constructed differently depending on their intended use. The different types of stock index formats are usually identified with how the index value is calculated. The three primary stock index types (and indeed, the only three that I have encountered) are price-weighted, value-weighted, and equal-weighted.
Price-weighted indexes derive index value by calculating a simple average of the component stock's prices. The index is then adjusted over time for dividends, stock splits, and substitutions. It is by far the simplest method of index calculation, and in fact, the oldest (and arguably the most closely watched) stock index of all, the Dow Jones Industrial Average (DJIA), uses the price-weighted method.
Perhaps surprisingly--considering its use with the DJIA--price-weighted indexes have the most problems and the fewest redeeming virtues. While simple to calculate initially, the older a price-weighted index gets, the more unwieldy adjustments have to be cobbled on to account for splits and whatnot. Furthermore, moves in the index will not reflect percentage changes in the underlying stock. If a 50 dollar stock and a 100 dollar stock both move up 1%, the 100 dollar stock will have twice the impact on the index. This effect results in an over-weighting of the highest price stocks, and it fails to accurately reflect overall portfolio performance.
Value-Weighted Method (a.k.a. Market Cap Method, or Market Value Method)
In a value-weighted index, companies are apportioned share in the index in proportion to their total company market capitalization. This weighting solves the problem of a 1 move in a 10 dollar stock having the same impact as an identical move in a 100 dollar stock, despite the fact that the former situation represents a 10 percent change, and the latter only a 1 percent change. Not surprisingly, then, value-weighted indexes are by far the most common. The classic example always provided for the value-weighted index style is the Standard & Poor's 500 Index.
The primary criticism of value-weighted indexes is that the largest companies will invariably make up a very large share of any moves in the index. In answer to this criticism, however, note that the largest companies have the largest impact on our economy. Furthermore, the largest companies are the most widely owned as well, so a move in a stock market giant has a greater impact on people's wallets than a comparable move in a smaller company.
Equal-Weighted Method (a.k.a. Unweighted-Method).
Indexes designed with the equal-weight method are intended to represent the performance of each listed stock in equal proportion, regardless of market capitalization. The argument favoring indexes of this structure is that it shows the returns expected by an investor who puts equal amounts of money in each stock. Equal-weighted stock indexes do not represent overall economic health or market performance, however. Smaller companies have proportionately fewer investors, so, logically, a very small company shouldn't have equal representation with a huge multi-national corporation. Value-Line offers a pair of equal-weighted stock indexes, but for the most part, very few indexes are constructed using this method.