What is the portfolio interpretation of index movements?
It is easy to create a portfolio, which will reliably get the same returns as the index. i.e. if the index goes up by 4%, this portfolio will also go up by 4%. Suppose an index is made of two stocks, one with a market cap of Rs.1000 crore and another with a market cap of Rs.3000 crore. Then the index portfolio will assign a weight of 25% to the first and 75% weight to the second. If we form a portfolio of the two stocks, with a weight of 25% on the first and 75% on the second, then the portfolio returns will equal the index returns. So if you want to buy Rs.1 lakh of this two-stock index, you would buy Rs.25,000 of the first and Rs.75,000 of the second; this portfolio would exactly mimic the two-stock index. A stock market index is hence just like other price indexes in showing what is happening on the overall indexes — the wholesale price index is a comparable example. In addition, the stock market index is attainable as a portfolio.
