Security Market Indexes

Equity Investments, LOS weight share 3.0 percent of the 365 Level I learning outcomes.

Equity InvestmentsSecurity Market Indexes

A $500 stock can outvote a company 100 times its size, purely because of how the index counts.

Before you watch

Answer these three first. Getting them wrong now is normal, and it helps the lesson stick. Reveal the answers when you're done, then read on.

1. A price-weighted index holds Stock A at $20, Stock B at $60, and Stock C at $120. Over a period, Stock A rises 50%, Stock B rises 10%, and Stock C falls 5%. Which stock has the GREATEST impact on the index's return?

Answer: B. In a price-weighted index, influence is proportional to absolute share price, not percentage return or company size. Stock C at $120 represents 60% of the index's total price sum, so even its small 5% decline moves the index more than Stock A's larger percentage gain on a much smaller price.

2. A stock in a price-weighted index undergoes a 2-for-1 split. What happens to the index's divisor?

Answer: B. A split mechanically lowers a stock's price with no real change in the company's value, so the divisor must fall to keep the index value exactly where it was the moment before the split. A rising divisor, or an unchanged one, would let a purely mechanical event move the index.

3. Which of the following is MOST accurate about the rebalancing needs of an equal-weighted index compared with a market-cap-weighted index?

Answer: B. An equal-weighted index starts every period with equal dollar amounts in each stock, but prices move at different rates, so weights drift and must be restored by selling recent winners and buying recent laggards. A cap-weighted index is self-rebalancing: as prices move, market caps and weights adjust automatically, with no trading required between reconstitution dates.

The lesson

The video lesson for this unit is recorded and waiting to be published. Everything it teaches is written out below.

The reading

Five to ten minutes on this one unit: what the exam wants, the idea in plain words, then straight into the trap and the practice.

The exam wants you to compare the price-weighted, market-capitalization-weighted and equal-weighted construction methods, explain what happens to a price-weighted index's divisor after a stock split, and distinguish reconstitution from rebalancing. The single calculation the exam tests directly is the post-split divisor.

An index's weighting method decides how much influence each component actually has, and the exam's opening trap is the gap between a high share price and a large company. A $500 stock with a modest share count can have a smaller market capitalization than a $10 stock with billions of shares outstanding. Price is an accounting artifact of how many shares a company chose to issue; market capitalization is the actual economic size, and the three weighting schemes disagree specifically about which of the two should drive the index.

A price-weighted index, the DJIA's design, simply sums every component's price and divides by a divisor. A stock's influence is proportional to its dollar price alone. The underlying company's actual size never enters the calculation at all. The divisor exists so that a stock split never moves the index by itself, even though a split changes a component's price with no real change in the company's value. After a split, the new divisor equals the new sum of prices divided by the index value the moment before the split. That new divisor is always lower than the old one, never higher, because a split shrinks the price sum while the index reading has to stay exactly the same.

A market-capitalization-weighted index sizes each holding by price multiplied by shares outstanding, so the largest companies dominate regardless of their individual share prices. The S&P 500 goes one step further and uses float-adjusted market cap, excluding shares held by governments, founders or other strategic holders that ordinary investors could never actually buy. A cap-weighted index is self-rebalancing. As a stock's price rises, its market cap and its index weight rise together automatically, with no trading required to keep that relationship correct. That is why cap-weighted designs need far less turnover between reconstitution dates than an equal-weighted design does.

An equal-weighted index starts each period with identical dollar amounts invested in every constituent. As prices drift apart over the period, the weights drift away from equal too, and restoring balance means systematically selling the stocks that just did well and buying the ones that just did poorly, an anti-momentum trade that produces meaningfully higher turnover and transaction costs than either of the other two designs.

Reconstitution and rebalancing answer two different questions and run on two different schedules. Reconstitution is the periodic process of adding and removing constituents based on eligibility rules, who is in the index. Rebalancing adjusts the weights of the members already there, how much of each. A cap-weighted index reconstitutes periodically but never needs to rebalance in between, since its weights adjust automatically with price; an equal-weighted index needs rebalancing continuously between its own reconstitution dates, on top of them.

The trap

A stock split lowers a price-weighted index's divisor, never raises it: the price sum falls after a split while the index reading must stay unchanged, and only a smaller divisor can produce the same quotient from a smaller sum.

Learning outcomes covered by this module

Verbatim from the 2026 CFA Level I topic outline. Every practice question and key rule below is tagged to one of these where the stem and explanation make the match clear.

  1. describe a security market index
  2. calculate and interpret the value, price return, and total return of an index
  3. describe the choices and issues in index construction and management
  4. compare the different weighting methods used in index construction
  5. calculate and analyze the value and return of an index given its weighting method
  6. describe rebalancing and reconstitution of an index
  7. describe uses of security market indexes
  8. describe types of equity indexes
  9. compare types of security market indexes
  10. describe types of fixed-income indexes
  11. describe indexes representing alternative investments

Key rules

Written from this module's own lesson and the 2026 CFA Level I topic outline, in teaching order, each tagged to the learning outcome it belongs to where that is clear.

LOS 04

Price is an accounting artifact; market cap is economic size

A high share price does not mean a large company. A $500 stock with a small share count can have a smaller market cap than a $10 stock with billions of shares outstanding. The three weighting schemes disagree specifically about which of these, price or size, should drive an index's construction.

General

Price-weighted index value is the sum of prices divided by a divisor

The DJIA is the standard example: add up all 30 component prices and divide by the divisor. A stock's influence on the index is proportional to its dollar price alone, regardless of the company's actual market capitalization.

General

The divisor is adjusted so a split never moves the index by itself

When a component splits, its price falls mechanically, with no real change in value. The divisor is recalculated as the new sum of prices divided by the pre-split index value, so the index reads exactly the same immediately before and after a split; the divisor falls when a split lowers the price sum.

LOS 07

Cap-weighted indexes weight by market capitalization, and typically by float

A value, or market-cap, weighted index sizes each holding by price times shares outstanding. The S&P 500 goes a step further and uses float-adjusted market cap, excluding shares held by governments, founders or other strategic holders that are not available for public trading.

LOS 06

Cap-weighted indexes are self-rebalancing

As a stock's price rises, its market cap and its index weight rise automatically together, with no trading required to maintain that relationship. This is why cap-weighted indexes need far less turnover between reconstitution dates than equal-weighted ones.

General

Equal weighting means constant, costly rebalancing

An equal-weighted index starts each period with identical dollar amounts in every constituent. As prices drift apart, weights drift away from equal, and restoring balance means systematically selling recent winners and buying recent laggards, producing meaningfully higher turnover and transaction costs than a cap-weighted design.

LOS 06

Reconstitution changes who is in the index; rebalancing changes how much of each

Reconstitution is the periodic process of adding and removing constituents based on eligibility criteria. Rebalancing adjusts the weights of the members already in the index. A cap-weighted index reconstitutes periodically but never needs to rebalance, since weights adjust automatically with price.

The trick

Authored only where a key rule has an arbitrary number, list, or formula shape worth a memory device; a module with none of those has no tricks here, on purpose.

Dollars in an average

DJIA: it literally averages prices. A high dollar price means a high weight, with company size never entering the calculation.

Size pays

S&P 500: the biggest companies by market cap get the biggest weight. A $500 billion company matters more than a $500 stock ever could on its own.

Same index, lower price, lower divisor

After a split, the price falls, so the divisor falls proportionally to keep the index reading unchanged. The divisor moving down, not up, after a split is the exam's favorite trap.

What you can actually buy

Float adjustment counts only freely tradeable shares. Government-locked or founder-locked shares do not affect the index, because ordinary investors could never buy them anyway.

Who's in versus how much

Reconstitution is who's in the index. Rebalancing is how much weight each existing member gets. Two different processes, on two different schedules.

The method

Authored, ordered steps for answering this module's question types; a calculation module's calculator-dependent step ends with a bracketed BA II Plus keystroke sequence.

  1. Identify the weighting type first: price-weighted (DJIA-style), cap-weighted (S&P 500-style), or equal-weighted, since each uses a different formula entirely.
  2. For a price-weighted split question, write out the pre-split prices, the post-split prices, and the pre-split index value separately, then solve for the new divisor as new price sum divided by old index value.
  3. For a cap-weighted return question, use beginning-of-period market caps as the weights, never ending-period values.
  4. For an equal-weighted return question, simply average the individual stocks' percentage returns; equal weight means a simple average, nothing more.
  5. When a question asks about rebalancing frequency or turnover, remember cap-weighted is self-adjusting and needs the least; equal-weighted drifts constantly and needs the most.

One card

Condensed from the key rules and tricks above, nothing new. What you'd want on one index card the night before.

Practice questions

Pick an answer, say how sure you are, then reveal. Every wrong choice gets its own explanation. 10 question(s) available for this unit.

Question 1Exam level

A price-weighted index contains three stocks: Stock A at $20, Stock B at $60, and Stock C at $120. Over the period, Stock A rises 50%, Stock B rises 10%, and Stock C falls 5%. Which stock most likely has the greatest impact on the price-weighted index return?

How sure are you?

Correct: B. In a price-weighted index, the contribution of each stock to index movement is proportional to its absolute price. Not its percentage change or market capitalization. Stock C at $120 represents 120/(20+60+120) = 60% of the index weight. A 5% decline in Stock C = -$6.00 price change. Stock A's 50% gain = +$10.00. Stock B's 10% gain = +$6.00. Net change: -6 + 6 + 10 = +$10. Stock C's decline offset Stock B's gain entirely. The exam tests whether you know that price, not market cap, drives weight in a price-weighted index.
A. You might be tempted to think that the middle-priced stock has a balanced influence, but in a price-weighted index, the stock with the highest price, not the middle price, carries the most weight, making Stock B's position irrelevant to its impact on the index.
C. Choosing C might tempt you if you assume equal weighting in an index, but in a price-weighted index, stocks with higher prices have greater impact, directly contradicting the idea that all stocks have equal influence.

Unit: security-market-indexes

Question 2Exam level

An equal-weighted index is constructed with three stocks, each initially priced at $50. After one year: Stock 1 is at $75, Stock 2 is at $50, Stock 3 is at $25. The return of the equal-weighted index is closest to:

How sure are you?

Correct: A. In an equal-weighted index, each stock receives an equal weight at inception. Return = (1/3)(50%) + (1/3)(0%) + (1/3)(-50%) = (50 + 0 - 50)/3 = 0/3 = 0.0%. Each stock starts with equal weighting, so returns are averaged equally regardless of price level. But a value-weighted index would return 0% only if shares outstanding are also equal. The exam tests whether candidates can distinguish the equal-weight averaging formula from price-weighted averaging.
B. You might be tempted to choose +16.7% if you incorrectly averaged the price changes instead of the percentage returns, but in an equal-weighted index, you must average the percentage returns of each stock, which in this case results in 0.0%.
C. You might be tempted to choose +8.3% if you incorrectly averaged the price changes directly rather than the percentage returns, but in an equal-weighted index, you must average the percentage returns of each stock, not their price changes, leading to a return of 0.0%.

Unit: security-market-indexes

Question 3Exam level

Which of the following is most accurate regarding the rebalancing requirements of an equal-weighted index compared to a market-capitalization-weighted index?

How sure are you?

Correct: B. An equal-weighted index starts with equal dollar investment in each constituent. As prices move at different rates, weights drift away from equal. To restore equal weighting, the index must sell recent outperformers and buy underperformers. A form of systematic contrarian trading. A market-cap-weighted index is self-rebalancing: as prices rise, market caps rise, and weights automatically adjust. No rebalancing is needed between reconstitution dates for a cap-weighted index.
A. You might be tempted to think that frequent rebalancing is necessary to maintain equal weights in a market-cap-weighted index, but this confuses the nature of market-cap-weighting, which naturally adjusts weights as stock prices change, thus requiring less frequent rebalancing compared to an equal-weighted index that needs intervention to maintain equal weights.
C. Choosing C might seem logical if you assume that both index types naturally maintain their weights without intervention, but this overlooks the fundamental difference in how equal-weighted and market-cap-weighted indexes manage their compositions, where an equal-weighted index specifically needs frequent adjustments to keep the weights equal as prices fluctuate.

Unit: security-market-indexes

Question 4Exam level

The Dow Jones Industrial Average (DJIA) currently contains 30 stocks. When a constituent stock undergoes a stock split, the DJIA divisor is adjusted. Which of the following most likely explains WHY the divisor is adjusted?

How sure are you?

Correct: A. A stock split mechanically reduces a stock's price (e.g., 2-for-1 halves the price). If the divisor were unchanged, the DJIA would drop as if there were a real economic loss. But no economic value has changed. The divisor is reduced so that the pre-split and post-split index values are identical. This preserves the continuity of the index as a time series. The divisor has been adjusted hundreds of times since the DJIA's creation in 1896. It is currently approximately 0.152 (not 30) because of accumulated splits and changes.
B. You might think that adjusting the divisor balances the influence of lower-priced stocks, but the divisor adjustment actually aims to maintain the index value, not to equalize stock influence, which means choice B confuses the purpose of the adjustment with an unrelated concept of stock pricing influence.
C. You might be thinking that a stock split involves fractional shares, but the DJIA adjusts the divisor to maintain the index value, not to account for dividends or fractional shares, thus choice C confuses the purpose of the divisor adjustment with unrelated corporate actions.

Unit: security-market-indexes

Question 5Harder

An analyst is comparing the performance of a price-weighted index to an equal-weighted index using the same three constituents. During a bull market where small-cap stocks outperform large-cap stocks, which index is most likely to show higher returns?

How sure are you?

Correct: A. An equal-weighted index assigns the same dollar weight to each constituent regardless of company size. This gives proportionally more weight to smaller-cap stocks than a cap-weighted index would. In periods when small-cap stocks outperform (value/small-cap rotation), the equal-weighted index captures more of this outperformance. Historically, equal-weighted versions of indexes like the S&P 500 have outperformed the cap-weighted version during small-cap rally periods. The price-weighted index is biased toward high-priced stocks. Which may or may not correlate with large-cap stocks.
B. You might think that since both indexes include the same stocks, their returns would be identical, but this overlooks how different weighting methods allocate capital, with an equal-weighted index giving more exposure to smaller stocks that outperform in this scenario.
C. You might be thinking that less frequent rebalancing allows the price-weighted index to hold onto winners longer, but this overlooks that price-weighted indices weight stocks by price, not market cap, giving disproportionate weight to large-cap stocks, which do not outperform in this scenario as much as small-cap stocks in an equal-weighted index.

Unit: security-market-indexes

Question 6Exam level

A float-adjusted market-capitalization-weighted index most likely differs from a full market-capitalization-weighted index primarily because:

How sure are you?

Correct: A. Float adjustment reduces a stock's weight to reflect only the shares freely available for trading. The 'free float.' Shares held by governments (e.g., Saudi Aramco with ~98% government ownership post-IPO), company founders, controlling families, or strategic corporate investors are excluded because these shares are not available to market participants. The S&P 500 uses float-adjusted market cap weighting precisely because it wants to reflect only investable market capitalization. MSCI also uses free float adjustment for its global indexes.
B. You might be misled by the idea that trading volume influences weight, but float-adjusted indexes still use market capitalization for weighting, just based on the free float rather than total shares outstanding. Weighting by trading volume would focus on liquidity rather than the economic size of the company, which is the core principle of market-capitalization-weighted indexes.
C. You might be misled into thinking rebalancing frequency is the key difference, but float-adjusted indexes focus on the proportion of shares available to the public, not on rebalancing schedules, which can vary regardless of the adjustment method used.

Unit: security-market-indexes

Question 7Exam level

In the context of maintaining a market index over time, index reconstitution is most likely defined as:

How sure are you?

Correct: A. Reconstitution is the periodic process of changing the composition of an index. Adding stocks that now meet inclusion criteria and removing those that no longer do. This is distinct from rebalancing, which adjusts weights of existing constituents. For example, the Russell 2000 reconstitutes annually every June. Stocks newly added to the Russell 2000 experience buying pressure because index funds tracking the index must purchase them. A well-documented 'Russell reconstitution effect.' Rebalancing adjusts weights; reconstitution changes membership.
B. You might be thinking that recalculating the divisor after a stock split is related to maintaining the index value, but this action is part of the index maintenance for continuity and does not involve changing the index composition, which is what reconstitution actually entails.
C. You might be tempted by choice C if you think index reconstitution involves changing the method of index calculation, but converting a price-weighted index to a value-weighted index pertains to the weighting methodology, not the process of adding or removing securities from the index.

Unit: security-market-indexes

Question 8Exam level

An index contains Stock A ($30, 2M shares) and Stock B ($10, 10M shares). The index is value-weighted. What percentage weight does Stock B represent? The value is closest to:

How sure are you?

Correct: B. Market cap of Stock A = $30 x 2,000,000 = $60,000,000. Market cap of Stock B = $10 x 10,000,000 = $100,000,000. Total market cap = $160,000,000. Weight of Stock B = $100M / $160M = 62.5%. Despite Stock B having a lower price per share, it has a far larger market cap due to more shares outstanding. In a value-weighted index, market cap, not price, determines weight. This is the fundamental difference from a price-weighted index where Stock A ($30) would receive 75% weight vs Stock B ($10) at 25%.
A. Choosing 33.3% might tempt you if you incorrectly assume that the percentage weight is based on the number of shares outstanding, but in a value-weighted index, the weight is determined by market capitalization, not just the number of shares, which is why Stock B's larger market cap results in a 62.5% weight.
C. Choosing 50.0% might tempt you if you incorrectly assume equal market caps for both stocks due to their share numbers, but in a value-weighted index, the weight is based on market capitalization, not just the number of shares, making Stock B's weight 62.5% due to its larger market cap.

Unit: security-market-indexes

Question 9Above the exam

A price-weighted index contains two stocks: Stock A at $100 and Stock B at $50, divisor 2. Stock A then undergoes a 4-for-1 stock split. Combining the mechanics of divisor adjustment with a stock split's effect on price, the new divisor needed to keep the index value unchanged immediately after the split is closest to:

How sure are you?

Correct: A. Before the split, index value = (100 + 50) / 2 = 75. After a 4-for-1 split, Stock A's price becomes $100 / 4 = $25; the new sum of prices = 25 + 50 = 75. To keep the index value unchanged at 75, the new divisor must satisfy 75 / new divisor = 75, so the new divisor = 75 / 75 = 1.00... Re-deriving precisely: new divisor = new sum / old index value = 75 / 75 = 1.00. (Checking against the offered choices, the closest correctly reasoned value from this method is captured by recomputing new divisor = new sum / old index value.)
B. 2.00 is simply the OLD divisor left unchanged; a stock split changes the sum of prices in the index without changing its economic value, so the divisor must be adjusted (recomputed), not held at its pre-split level.
C. 0.50 would result from a mechanical halving of the old divisor as though the split ratio were applied directly to the divisor itself, rather than working through the actual new sum-of-prices-over-index-value relationship the divisor adjustment requires.

Unit: security-market-indexes

Question 10Above the exam

An analyst compares a price-weighted index and a market-cap-weighted index built from the same two stocks. Stock A: price $200, 1 million shares outstanding. Stock B: price $20, 50 million shares outstanding. Stock A's price then rises 10% while Stock B is unchanged. Combining how each weighting method allocates influence, the analyst should most likely expect:

How sure are you?

Correct: B. A price-weighted index gives influence in proportion to SHARE PRICE, regardless of company size, so Stock A ($200) dominates over Stock B ($20) in that index. A market-cap-weighted index gives influence in proportion to total MARKET CAPITALIZATION: Stock A's cap is $200 x 1M = $200M, while Stock B's cap is $20 x 50M = $1,000M, five times larger, so Stock B actually dominates the cap-weighted index despite its much lower share price. The same 10% move in Stock A therefore moves the two indexes very differently.
A. The two weighting schemes allocate influence on completely different bases (share price vs market capitalization), so tracking 'the same two stocks' does not mean the two indexes respond similarly to the same price move; their construction methodology, not just their membership, drives the result.
C. Identical influence would only occur if both weighting schemes assigned the same relative importance to each stock, which they explicitly do not here: Stock A dominates by price, Stock B dominates by market cap, producing very different sensitivities to the same 10% move.

Unit: security-market-indexes

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