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What is "Index Weighting"?

The indexes that we use to track the stock market are composed of many stocks - 500 in the All Ordinaries Index. The index may be a simple average or every stock may be treated the same in the index. However, the most sophisticated indexes are capitalisation weighted. The capitalisation of a stock is its price multiplied by the number of shares it has issued. So, capitalisation measures it total market value. What this means is that the larger companies have more importance in the index. This is known by the statistical term "weighting". So, News Corp may be 15% of the index, NAB may be 10%, BHP may be 9% and so on. An ideal portfolio, which is aiming to track the index will be constructed using the same weighting for each stock as it has in the index (it is more complicated than this, but that is the idea). If a portfolio manager thinks he or she can beat the index, they will vary the weighting so that the stocks they think will do best have a heavier than index weighting and the stocks that they think will do worst have a lower weighting. So, if an analyst suggests to you that you go "over-weight" in a stock, they mean that you should be holding a greater weighting in your portfolio than that stock has in the index. The reverse applies to "under-weight".

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