Weighted Average – What Is It
When learning about trading and investing, likely, you have already used the concept of average or averaging. In fact, the moving average, one of the simplest and common trading indicators, uses the idea of averaging.
If you have paid attention to your math class, you should know how to get the average. However, the traditional average has its weaknesses. As a way to offset its weakness, the concept of the weighted average is born.
So what is a weighted average? What makes it different? And, is it useful? In this article, you will learn about the answer to these questions and more.
What does the weighted average mean?
The weighted average is the average value of a particular set of numbers with different levels of relevance.
So what is a weighted average calculation?
Simple weighted average formula
Weighted Average = W1 x1 + W2x2 + W3x3…..wnxn where W is relative weight in % and x number.
To better understand the weighted average, it’s best to start with your traditional average. With a traditional average, you add multiple data points and then divide them equally. What makes the weighted average difference is it puts more importance on one or more data points. As a result, your final calculation will differ from a traditional average as the weighted average will put more “weight” on pre-determined data points.
Calculating for the weighted average is also different from your traditional average. As mentioned above, the traditional average will add all the data points as a first step. With a weighted average, the first step is to multiply the data point with an assigned number. After you get the product for all the data points, you then add them and divide them like your traditional average.
The assigned number is arbitrary, and it largely depends on who is doing the calculation. However, the result is the same. And that is one or more data points that will have a larger impact on the overall average.
Why Do They Use Weighted Average?
There are plenty of instances why the weighted average is better than your traditional average. One of the most common reasons for its use is to get a more accurate picture of the data set.
For example, you’d want to know the average price of a stock in the time span of one year in an attempt to predict its future price. You start by taking note of the price at each end of the month. So in total, you have twelve data points.
However, you suddenly think that the December price should be more important than the January price because it’s more recent. And, by placing more importance on the more recent data points, you think you’ll be able to predict the price movement better. In this specific case, you’ll need to use a weighted average. You assign a bigger number on the recent prices and a lower number on the latter prices. As a result, your average is weighted towards recent prices.
Keep in mind that the scenario above is just an example, and don’t think it’s a holy grail or some sort. In fact, there’s already an indicator for such, and it’s called the weighted moving average. Also, there are other applications of the weighted average, like in a stock portfolio.
Weighted Average In Stock Portfolio
It is typical for investors to buy the same stock over and over again over many years. It will be challenging to keep track of the share’s cost and how much the change in value.
One way to solve this problem is by doing a weighted average to get a clearer picture of the average purchase costs for a specific stock. To do this, take note of the number of shares and the stock price at the purchase time. Then, multiply the two together. Repeat the process for each time you buy a stock. Then, add all of the product and divide it with the total shares. You will arrive with a number that’s a weighted average stock cost.
Weighted average example 1:
As an example, an investor buys 100 shares at $10. After a year, the investor buys another 50 shares at $40 of the same stock. To get the weighted average stock price, start multiplying 100 shares by 10, 50 shares by 40, and then add the two. You’d arrive at several $3,000. The last step is to divide $3,000 with the total shares, which is 150. You’ll have a weight average stock price of $20.
Weighted average example 2:
Weighted average growth calculation and the weighted average rate of return :
Total initial investment = $30,000
5% growth on $20,000 = $21,000
15% growth on $10,000 = $11,500
Combined value after year 1= $32,500
($32,500- $30,000) / $30,000 = 8.33%
The weighted average rate of return is 8.33%
Wrapping It All Up
The weighted average is a variation of the traditional average. It differs in that it allows one or more data points to impact the final average result significantly. It has plenty of applications, from trading indicators to stock portfolio management.