What is an Index? (ii)

In the previous post we learnt about terms like market cap and shares outstanding. We also discussed how stocks can be selected to be included in an index and how in a basket of stocks though number of shares remains constant, weights keep changing due to price change.  

Let’s continue with the same example of IT industry.  We had selected 10 stocks, representing 90% of the total market cap of IT industry, to be included in our basket/index.  Now suppose instead of 10 stocks we want to retain only 5 stocks in an equal weighted basket. Weight of each stock would then be 20% and a Rs.1000 investment in this basket would result in Rs.200 investment in each stock.   

Let’s assume instead of equal weights, I assign different weights to the stocks and allocate 30% weight each to 3 stocks and 5% each to 2 other stocks. If I now invest Rs.1000 in the index, Rs.300 each will be allocated to the stocks with 30% weightage and Rs.50 each to 2 stocks with 5% weightage. Lets again recall that stock weightage is equal to value of investment in the stock divided by the total value of all investment.

Let’s assume you invest Rs 5000 in an equi-weighted index of 5 stocks. Each stock will have a weight of 20% at the time of investment and will be allocated Rs 1000. Let’s see what happens as the share prices of stocks change on subsequent days.

Investment Day

Investment Day +1 (Next day, prices of all the stocks will change, but the no of shares will remain same) 

Investment Day +2 (prices will change again, but the no of shares bought will still remain same)

As can be observed, after we bought the index price of stocks and because of that weights of stocks within the basket kept changing. However number of shares will always remain constant. On day 1, at the time of investment, value of my portfolio was Rs 5000. On day 2, it changed to Rs 6050 and on Day 3 it changed to Rs 7100.

To understand how to calculate profits and arrive at an Index value, read on.