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Investment Analysis and Portfolio Management

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Investment Analysis & Portfolio Management (FIN630)
VU
Lesson # 25
MARKET INDEXES
Introduction:
Indexes are useful in assessing investment results. They provide a benchmark against which
performance can be compared. They also useful in financial research, through which an
investigator seeks to discover the relationship between certain economic variables and
market results. In fact, most of us keep abreast of developments in "the market" by
watching the indexes. Because television or radio announcers cannot possibly cover price
changes for every security, they quote the value of some well-known market measure, such
as the Dow Jones Industrial Average. On-the-hour radio news frequently concludes with a
statement such as "On Wall Street, the Dow Jones Industrial Average is up 123 points on
volume of 630 million shares." To investors everywhere, this news is an indicator of the
day's market activity and a good clue as to what is happening with their own favorite
securities. This chapter provides an overview of some of the most popular indexes.
Index Construction:
Indexes can be useful in following investment performance, but only if an investor knows
what the index is measuring and how similar the index is to a particular investment
portfolio. Knowing that the general level of bond prices in Singapore declined today may
not tell investors much about how U.S computer stock fared.
Price Weighting:
A price-weighted index is composed of a single share of each of the index component,
regardless of the price of the share or the size of the underlying company: the Dow Jones
Industrial Average (DJIA) is an example of such an index. The first step the 30 industrial
companies comprising the index.
A problem with a price-weighted index lies in the distortions that occur when a company in
the index chooses to split its stock. On day one the value of a portfolio composed of one
share in each of the three stocks is $60. On day two, company a splits its shares three for
one, which causes company A's share price to fall to $10. One share in each of the three
companies now costs a total of $40.
Someone unaware of company A's stock split would observe the decline in the index from
$60 to $40 and conclude that the market lost a third of its value overnight. This conclusion
however would obviously be inaccurate because the decline in value stemmed purely from
an accounting change.
To deal with this problem, analyses use a divisor to adjust the value of the portfolio before
reporting the final value of the index. The divisor ensures the index does not change
artificially because of the split.
Some interpretation problems arise with a price-weighted index. For one thing, high-value
stocks carry more weight than lower-valued issues, which may distort the bigger picture the
index purports to provide. Also price weighting carries a bias against a growth stock. As its
price raises a growth stock share carries more weigh in the index. After the shares reach too
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