Weighted Average Market Capitalization
What it is:
Weighted Average Market Capitalization refers to a stock market index in which larger companies (i.e. with higher market capitalization) have more influence on the index's performance.
How it works (Example):
Various stock market indices follow selected companies based on their niche (e.g. industrials, technologies, small caps, etc.). These indices track according to the companies in the index. For example, if the stock prices of the companies in the index go up, the index will go up. Most indices weight the average performance of the companies in their index by the market capitalization of each company. This way, larger companies, usually measured as those with higher market capitalizations (i.e. price per share X outstanding shares), have more influence over the index. The S&P 500, for example, uses a weighted average market capitalization to measure performance.
In contrast, for example, the Dow Jones Industrial Average uses a price-weighted index. That is, irrespective of the size of the company, the share price is used as the weighting the average of all stocks in the index. The higher share prices have more influence over the performance of the index.
Why it Matters:
Investors should understand the composition of the stocks in a particular index, especially if it is used to track portfolio performance. Using a market capitalization to weight the stocks in an index, an investor can quickly see which sectors are emphasized by a particular index.
