What is an Index?

We have discussed what a market index represents and why we track it. In this post let’s learn more about the market index.

The term index usually refers to a basket of some finite assets (stocks/bonds/commodities etc) which as a group forms the best representation of the space in which many similar assets lie. Let’s say we want to create an index to represent Indian IT industry. As per our definition of index, this should be a basket of IT companies that best represent the IT sector. There are many IT companies listed on the exchange, so the natural question is which companies should be selected to be included in the basket? It’s important to define some basic terms at this point

Shares Outstanding = Total number of shares issued by the company

Market Cap = Current Price * Shares Outstanding
(This tells me what is the current value of a company)

Suppose a company X has issued 100 shares and the current price of each share is Rs 10, then the market cap of company X will be Rs 1,000. It means that the total value of the company (cumulative value of all shares) is Rs 1,000. Each listed company in IT sector will have its own market cap/value. If we add all these market caps, we will get the total market cap of IT sector ie combined value of all the listed companies in the IT sector.

Let’s revert to the question of selecting stocks for our Index. Let’s say there are 1000 companies in the IT sector. 10 companies, out of 1000, are very big and represent almost 90 percent of the total market cap of the sector. So the combined market cap of the other 990 companies will amount to only 10% of the sector market cap. Since 10 companies represent most of the market cap of the sector, we could just select these 10 to form a representative basket of the IT industry.

Suppose I want to invest in this IT basket and I have Rs 1000. If I decide to invest equally in all the 10 stocks, I will end up buying Rs.100 worth of shares of each one of these 10 stocks. Let’s assume Infosys is one of the stocks that I hold and I have Rs.100 worth of the company’s shares. So the company has a weightage of 10% (100/1000) of my investment amount.  Stock weightage is equal to value of investment in the stock divided by the total value of all investment. As I invested equally in all the 10 stocks, weightage of each of the stock in my portfolio is 10%.

Let’s assume that at the time of investment each share of Infosys cost Rs.50. Since I invested Rs.100 into the stock I would have got 2 (100/50) shares. Similarly with an investment of Rs.100 in each stock, I would have bought some fixed number of shares of each company.  Suppose after 2 days prices of all stocks except Infosys’s price remains unchanged. So leaving out the value of Infosys, the balance investment is still worth Rs.900. If the price of Infosys has shot upto Rs.90 from Rs.50 over the last 2 days, my investment in that company will now be worth Rs.180 (90 * 2 shares). Total value of investment of all 10 stocks would be Rs.1080 (900+180). Please recall we defined weight of each stock in the portfolio as value of investment in the stock divided by the total value of all investment. Hence weight of Infosys will now be 180/1080 = 16.67%. To make up for the increase in weight of one stock, weightage of all other stocks would have dropped down to 100/1080 = 9.26%.

The important takeaway from this example is that when we create an index or buy a basket, number of shares of each stock remains constant, however weightage of each stock does not. Weightage represents the portion of total value represented by a single stock and as the stock price changes everyday, weights do too. Let’s continue with our example in the next post.