Within the realm of financial analysis, stock indices are everywhere, but they are not without their limitations. Owing to the methods in which their value is calculated, sometimes using an index as an objective measure of economic performance may prove to be shortsighted. To learn more, read on.
The limitations of stock indices
Despite being widely accepted as a means of financial analysis, stock indices are not without their flaws. Owing to the methods by which their value is calculated, using stock market indices as an objective measure of economic performance can prove to be shortsighted.
Capitalisation-weighted indices
In the case of capitalization-weighted indices, companies with a disproportionately large market cap will impact the overall value of the index greatly, which may not truly reflect the performance of the stock market accurately.
This can be proven when looking at how the S&P 500 is structured, with the 10 largest companies accounting for roughly 25% of the index's total capitalization and the remaining 490 companies responsible for ~75%. Hypothetically, if the stock value of these ten companies were to fall 10% simultaneously, the S&P 500 would suffer a loss of at least 2.5%, even if the other 490 companies' stock prices were to remain unchanged.
By this virtue, it has been argued that this increases so-called 'herd behavior' in the market, as when stock prices of large-cap companies change, the capitalization-weighted indices they belong to are likely to 'overreact', encouraging traders to buy and sell en masse.
Price-weighted indices
On the other hand, price-weighted indices can suffer from a unique set of problems. For example, owing to the functionality of averages, higher-priced stocks will have a much larger impact on total index value when compared to their lower-priced counterparts.
Recognising that low-cap stocks can sometimes trade at high prices, this can become problematic as relatively small-sized companies can impact the performance of the index significantly, which may not reflect true market direction. The same would also apply in reverse for large-cap companies following a stock split, where a company divides and increases the number of shares available to buy or sell, lowering their stock price, respectively.
In practice, among the sixteen most common indices, the Dow Jones Industrial Average and Nikkei 225 are the only major stock indices to use price-weighted calculations, with most opting to use capitalization-weighted algorithms to determine market value.
Disadvantages of the different stock indices in summary
| Capitalization-weighted stock indices | Large-cap companies have significantly more influence in determining index value but are not sensitive to stock splits |
|---|---|
| Price-weighted stock indices | High-priced companies have more influence in determining index value, but stock splits can affect this |
