A weighted average is a calculation considers the relative importance or relevance of a piece of data. Weighted averages multiply numbers in the average by a predetermined factor, like time, that enhances the relevance given to the number.
One example of a weighted average is the Exponential Moving Average (EMA), an alternative to the Simple Moving Average (SMA) line which gives greater weight to the more recent data. SMAs are effective in their simplicity, but their efficacy is most closely tied to how they are used.
By giving equal weight to each data point, SMAs can limit bias towards any specific point in a given time period. Some traders argue that this is a negative; equal reliance on data from all points in time means an SMA does a poor job of truly reflecting a security’s most-current behavior, and its lag thus limits its predictive potential. Because an EMA weights recent data more heavily, it tracks trends more closely and is more accurate than a Simple Moving Average.
Weighting is valuable in multiple contexts. For example, the percentage of a portfolio that a specific investment represents can be multiplied by its rate of return to give us its own weighted return in relation to that portfolio; averaging the weighted values together gives us the weighted average return of the portfolio. In business valuations, the Weighted Average Cost of Capital helps to give proportional weighting to the cost of equity and the cost of debt as part of the entire capitalization of the company. Indexes also weight certain factors in their calculations.
Weighted averages are imperfect. Recency bias can increase the likelihood of a trader being convinced to trade on a short-term trend and losing in a whipsaw. It is important that traders compare averages of different lengths to develop a more complete understanding of trends, as different averages can produce completely different results. Which indicator or methodology a trader decides to use usually depends on their experience, skillset, and the quality of the tools (including artificial intelligence with Tickeron) available to help them find and verify trade ideas.