Here we want to give stock weights in proportion to their market capitalization. To understand the meaning of market capitalization, read our article What is an Index. To calculate the weight of each stock, we divide stock market cap by the total market cap of all stocks in the portfolio, as explained in the table below. Also, we know weight of an instrument is the portion of total portfolio value represented by that particular instrument. So the investment into each stock will be its weight multiplied by the total portfolio investment of INR 50,000.
|Stock||Market Cap in INR cr (C)||Weight (C/sum[C])||Investment in INR|
We will follow the same steps when we used the equi-weighted scheme.
The next step is to calculate shares of every stock, based on the investments that we calculated in the above step. Number of shares would be equal to investment in the stock divided by its current market price. We know that the share calculated in the last step might be fractional and thus non-executable on the exchange. For this reason, we change the fractional number of shares to nearest whole number. Once we have no of shares, actual investment amount is equal to no. of shares multiplied by current market price and final weight would be total actual investment divided by individual stock investment.
|Stock||Weight (A)||Investment in INR (B=A x 50,000)||Current Market Price (C)||Shares (D = B/C)||Rounded Shares||Actual Investment in INR (E = D1*C)||Final Weight (E/sum[E])|
In the market cap scheme, SBI has a weight of 68.09%, compared to 20.06% that we calculated in the equal weight scheme. Thus, market cap portfolio will be more exposed and sensitive to movement’s in SBI stock price, compared to equal-weight. This is happening because majority of your money is still concentrated in one particular stock and company specific risk is very high in the absence of proper diversification.
The third type of weighting scheme which we mentioned in our last post is Custom. In the eual-weight scheme the investment was divided equally among all the stocks. In the Market-cap scheme, it was divided based on the market capitalization of individual stocks. In Custom scheme, there is no set patter to derive this amount. Here the decision could be based on some exclusive information or investor’s gut feeling. For example, you might believe that PNB is expected to perform better than other stocks, then you can give a higher weight to PNB, compared to others. Once weighting scheme is decided, rest of the steps are similar to market-cap and equal-weight schemes.
Read the next post to learn how to calculate portfolio risk and return based on a custom index.