What it is:
Weighted average refers to the mathematical practice of adjusting the components of an average to reflect the importance of certain characteristics.
How it works (Example):
Here is information about five stocks.
We could average theirprices and it a day (i.e., we would calculate the average as $8.60).
However, this doesn’t take into account the issuers’ actual sizes or the number of shares outstanding (in other words, without reflecting the issuers’ true heft in the economy). The tiny companies can sway the as much as the more significant companies.
Accordingly, if one of the higher-priced stocks (Company D, in our example) has a huge price increase, the index is more likely to increase even if the other, more meaningful companies in the index decline in value at the same time.
Thus, we could create a weighted average to give more weight to the bigger issuers. We could do this by multiplying the share price by the shares outstanding, summing the totals, and then dividing by the total shares outstanding:
Why it Matters:
In the finance world, some indexes involve weighted averages and some do not. It is important to understand how indexes are weighted so you know what influences those indexes, what the really conveys, and whether the is relevant to your objectives.