Introduction:
Although the stock market is much more dynamic than the indexes suggest, along with the fact that
there are different ways to calculate the indexes, causing calculation bias, the stock market indexes
are useful in a number of ways to stock investors. First, the market indexes provide an historical
perspective of stock market performance, giving investors more insight into their investment
decisions. Investors who do not know which individual stocks to invest in can use indexing as a
method of choosing their stock investments. By wanting to match the performance of the market,
investors can invest in index mutual funds or index exchange-traded funds (ETFs) that track the
performance of the indexes with which they are aligned. This form of investing gives investors the
opportunity to do as well as the markets and not significantly underperform the markets.
Stock Market Index (SMI):
A stock index or stock market index is a measurement of the value of a section of the stock market. It
is computed from the prices of selected stocks (typically a weighted average). It is a tool used
by investors and financial managers to describe the market, and to compare the return on
specific investments. An index is a mathematical construct, so it may not be invested in directly. But
many mutual funds and exchange-traded funds attempt to "track" an index (see index fund), and
those funds that do not may be judged against those that do.
The Way to construct SMI:
A stock market index is a number that indicates the relative level of prices or value of securities in a
market on a particular day compared with a base-day figure, which is usually 100 or 1000. There are
many different ways of constructing an index. One of the most common methods is illustrated by the
following simple example. The values of a market portfolio at the close of trading on Day 1 and Day
2 are recorded below:
Trading days Value of portfolio Index
Day 1 (base day) Tk. 20,000 1000
Day 2 Tk. 21,000 1050
We take Day 1 as the base day. The index on that day will be taken as a standard. The value assigned
to the base day index is 1000 in this example. On Day 2 the value of the portfolio has changed from
Tk. 20,000 to Tk. 21,000, a 5% increase. Therefore, the value of the index on Day 2 will change to
indicate a corresponding 5% increase in market value. The computation follows the procedure below:
2's portfolio value
Day 2's index = ------------------------------------------------- * Base Day's (Day 1) index
Base Day's (Day 1) portfolio value
Tk. 21,000
= ---------------- * 1000
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Tk. 20,000
= 1050
Day 2's index is 1050 as compared to the 1000 of day 1. The above illustration only serves as an
introduction to how a particular index is constructed. The daily computation of an index is more
involved especially when there are changes in market capitalization of constituent stocks, e.g., rights
offers, stock dividend etc. The primary objective of constructing market indices is to measure the
performance of the market. The indices provide vital information about the current and historical
behavior of the market. Stock market indices differ from one to another basically in their sampling
and/or weighting methods.
Types of Index Calculation:
There are, in general, three different weighting methods, namely, value-weighted, equally-weighted
(or un-weighted), and price-weighted. Value-weighted method may be considered as a most
appropriate method than others for both the bourses of the country (DSE & CSE) since the existing
indices of the bourses have been calculating under value-weighted method. For a value-weighted
index, the weight of each constituent stock is proportional to its market share in terms of
capitalization. A stock index is essentially a barometer of stock market performance. As mentioned
earlier, an index is made up of a basket of stocks. This basket of stocks that make up the index is
usually carefully chosen to be representative of the market it is measuring. Indexes are essentially
statistical sampling. There are essentially three types of stock indexes, as follows:
a) An equally weighted (price weighted) index;
b) A value weighted (capitalization weighted) index;
c) A geometrically weighted index.
a) An Equally Weighted Index:
An equally weighted index weights each stock equally regardless of its market capitalization or
economic size (sales, earnings, book value). Due to daily price movements of the stocks within the
index, the portfolio must be constantly re-balanced to keep the positions in each stock equal to each
other. It is a type of weighting that gives the same weight, or importance, to each stock in a portfolio
or index fund. The smallest companies are given equal weight to the largest companies in an equal-
weight index fund or portfolio. An equally weighted index is computed by adding the closing prices
of the component stocks and dividing by divisor. Mathematically this is done as: Index= (The sum of
closing price of each component/ Divisor). Here divisor is statistical adjustment factor for
capitalization changes, stock, splits, bonus issues, rights and stock substitution.
Calculation Procedure with example:
For example, let's assume that the following companies are in the XYZ price-weighted index:
Company Share Outstanding Share Price
Company A 10,000,000 $5
Company B 5,000,000 $7
Company C 15,000,000 $10
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Company D 2,000,000 $20
Company E 7,500,000 $1
A price-weighted index is simply the sum of the members' stock prices divided by the number of
members. Thus, in our example, the XYZ index is: $5 + $7 + $10 + $20 + $1 = $43 / 5 = 8.6. In
a price-weighted index, stocks with higher prices receive a greater weight in the index, regardless of
the issuing company's actual size or the number of shares outstanding. Accordingly, if one of the
higher-priced stocks (Company D, in our example) has a huge price increase, the index is more likely
to increase even if the other stocks in the index decline in value at the same time.
Advantages
The index is highly diversified with all stocks in the universe equally weighted.
As opposed to market cap weighting, the index does not overweight overpriced stocks and
underweight underpriced stocks. Pricing errors are random.
Easy to construct relatively tax efficient ETFs and mutual funds.
Usually adds 1 2 percent in annual return over long periods after expenses vs. market cap
weighted indexes.
Disadvantages
No distinction is made between the relative or absolute valuation of stocks within the
universe.
Difficult to keep the stocks in the index equally weighted due to constant price fluctuations.
Difficult for this type of index to manage substantial amounts of money due to the need to
invest equal amounts in both the largest and smallest stocks.
b) Capitalization Weighted Index:
A capitalization-weighted (or "cap-weighted") index, also called a market-value-weighted index is
a stock market index whose components are weighted according to the total market value of
their outstanding shares. Every day an individual stock's price changes and thereby changes a stock
index's value. The impact that individual stock's price change has on the index is proportional to the
company's overall market value (the share price multiplied by the number of outstanding shares), in a
capitalization-weighted index. In other types of indices, different ratios are used.
The computation of a value-weighted index is useful to think in terms of evaluating the performance
of a portfolio of securities. Some adjustments need to be made due to changes in market
capitalization of the portfolio's constituent stocks. The adjustment procedures are discussed in detail
below. To make our computation simple, we need to keep the number of constituent stocks small. Let
us assume that the index is composed of only three stocks: X, Y and Z.
Calculation Procedure with example:
The formula underneath is simple way of seeing the percent changes that your ETF (or any other
shares of stock, for that matter) has gained (or loss). If an investor purchases 100 shares of AAPL at
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$1.00 and a month after the purchased AAPL is trading at $1.10, the investment yielded a 10%
gain/return (($110/$100)-1=0.1, or 10%).
Suppose there are three stocks in the index and computation begins on day t=1.
Stocks Number of stocks Close price on day Close price on day
outstanding t=1 t=2
X 5,000 5.00 5.40
Y 10,000 7.oo 6.80
Z 6,000 6.00 6.50
Index, t-1= [(5000*5.00+10,000*7.00+6,000*6.00)/(5000*5.00+10,000*7.00+6,000*6.00)]*100=
100points
Index, t-2= [(5000*5.40+10,000*6.80+6,000*6.50)/ (5000*5.00+10,000*7.00+6,000*6.00)]*100=
102.29 points
On day 2, the index would be reported to have gone up 2.29 points. In a capitalization weighted
index, larger capitalized firms would have the more influence. As such, the increases of the prices of
larger firms would be enough to move the index even in the other stocks were largely unchanged.
Criticism of this method:
One argument for capitalization weighting is that investors must, in aggregate, hold a capitalization-
weighted portfolio anyway. This then gives the average return for all investors; if some investors do
worse than some investors must do better (excluding costs).
Investors use theories such as modern portfolio theory to determine allocations. This considers risk
and return and does not consider weights relative to the entire market. This may result in
overweighting assets such as value or small-cap stocks, if they are believed to have a better return for
risk profile. These investors believe that they can get a better result because other investors are not
very good. The capital asset pricing model says that all investors are highly intelligent, and it is
impossible to do better than the market portfolio, the capitalization-weighted portfolio of all assets.
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However, empirical tests conclude that market indices are not efficient. This can be explained by the
fact that these indices do not include all assets or by the fact that the theory does not hold. The
practical conclusion is that using capitalization-weighted portfolios is not necessarily the optimal
method.
c) Geometrically Weighted Index
A simple arithmetic or geometric average used to calculate stock indexes. Equal weight is invested in
each of the stocks in an index with equal dollar amounts invested in each underlying stock. Because
the stocks are equally weighted, one stock's performance will not have a dramatic effect on the
performance of the index as a whole. This differs from weighted indexes, where some stocks are
given more weight than others, usually based on their market capitalizations. This method of index
computation is neither a common method nor very popular. This is due to the fact that it is very
difficult to replicate such an index. This value line index uses this method of computation is
computed as:
Index= Pit1 Pnt1 )]
(
n Pit
[ ) (
Pnt
Calculation of this method with example:
To calculate a geometric average, suppose again that there are three stocks in an index with returns of
10%, 11% and 15%. The geometric return would be calculated as follows:
[(1+0.1)*(1+0.11)*(1+0.15)]^(1/3) = 1.1198 = 11.98%
In this case, you multiply the returns and take the 'n'th (where 'n' equals the number of stocks in the
index) root of the product. The geometric average will either be equal to or lower than the arithmetic
average.
Uses of Security-Market Indexes:
As benchmarks to evaluate the performance of professional money manager
To create and monitor an index fund
To measure market rates of return in economic studies
For predicting future market movements by technicians
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As a substitute for the market portfolio of risky assets when calculating the systematic risk of
an asset.
Conclusion:
One of the most burning questions today is what the use of the capital market is and why the
government should get involved to stabilize the market. Apparently, it seems that stock market does
not keep any connection with the economy. But this market offers a great opportunity for the whole
economy if we can grab it properly: Firstly, the companies can arrange their long term capital for
business expansion from market with a minimum cost. The banks are suitable only for short term and
midterm financing. Secondly, the companies listed in the stock market come under regulation of
Securities and Exchange Commission, which ensures the corporate governance of the companies. The
financial statement of listed companies is quite informative and valuable than unlisted companies.
Thirdly, the most important factor is that stock market can attract investment. People reduce their
consumption and invest here to earn better in future. Fourthly, stock market can finance huge fund for
large projects easily. Finally, stock market is considered as the barometer of economy. An efficient
stock market is the leading indicator of the economy.
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