What is a weighted average?
A straightforward weighted average definition is an average of a set of data that gives more weight, or importance, to some of the numbers based on how often they occur.
There are different types of weighted averages. A volume-weighted average is the average weighted by the total volume. An equal-weighted average gives all numbers the same importance.
Where have you heard about weighted averages?
Weighted averages are used frequently in investing to calculate portfolio positions and returns, as well as technical analysis. You may have heard a weighted average explained in reference to stocks, funds, and company analysis.
What do you need to know about weighted averages?
Calculating weighted averages can help you to measure the value of your portfolio and make investment decisions.
For example, a weighted average is used to determine the average price of multiple purchases of a stock when the number of shares is not always the same. Weighted averages are used by index funds and mutual funds, which might have larger holdings of companies with higher market capitalisation, or give equal weight to each of the companies they hold.
Volume-weighted averages (VWAs) are used to determine the average price at which a stock traded during a trading session. A weighted average cost of capital (WACC) is used to analyse a company by measuring the cost of financing its debt and equity.
A weighted moving average (WMA) is a technical indicator that gives more weight to recent data over a certain time period and indicates price trends, support and resistance levels. It follows a price trend more closely than a simple moving average (SMA).
A weighted average of share purchases shows the cost basis, or value of your position, in relation to the current share price so you can see whether it is in profit.
You can set up a spreadsheet to automatically calculate weighted averages for you to track them easily. The formula for a weighted average is:
To use the example of the cost basis of a stock position, if you bought 10 shares of a stock at $50 per share, 20 shares at $48 per share, and 15 shares at $49.50 per share, the formula would be as follows:
(10 x 50) + (20 x 48) + (15 x 49.50) / 45 = 48.94
While the simple average of the three prices would be $49.17 per share, the weighted average takes into account that more shares were bought at the lower price, bringing the break-even price down to $48.94 per share. You might opt to buy the stock at a price below the weighted average to further reduce your cost basis, or sell it above the average to lock in a profit.
Applied across a portfolio, a weighted average can calculate the return on investment from different volumes of shares for different stocks.
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