How to create your own Share Index or Stock Index

 The technical details of this is found in inspired by: https://www.youtube.com/watch?v=dbF6tnZDzCQ   which gave a good explanation of how to calculate or create your own share index. The aim of this post is to give a bit more explanation and details.

Firstly, what is a share index and why do we need them? Put simply, a share index is a collective representation of a group, or basket, of shares. Instead of looking at the share price of an individual company, a share index price is the collective price of a group of shares. In the U.S. three of the popular Share Indices are the Dow Jones (a group of 30 companies), the Top 500 (a group of 500 companies) and the Nasdaq (a group of technology companies). The purpose of a share index is to provide a collective view so that it represents the market as a whole. Individual company share price may move up or down, but collective a share index give an overall picture of the market.

Secondly, as mentioned above there are many different share indices and they are created to represent different group of companies or different sectors in the market or even different countries. So it is up to the creator of the index to decide which stocks to include.

Thirdly, another variable in the share index is the amount of each of the specific stock. For example do we include 5 shares of Apple stocks and 10 shares of IBM stocks? The amount may be a reflection of which stocks we like to see having more or less in.

Here is a very simple example.

Step 1: Choose Stocks A, B, C; each with a certain amount; ie. number of shares, say 5, 10, 15. The share prices could be $1, $2, $3. Multiply the respective amount by share prices and add together. So $5 + $20 + $45 = $70. This represents Day 1's total Basket value. This is not the share index price yet. 

Step 2: Choose an arbitrary starting value of the index. This may be the most difficult to understand. Simply don't think about this step and choose a nice round number. Say 100 or 1000 or something. This is the Share Index price on Day 1.

Step 3: Repeat Step 1 for Day 2. Let's say the result of the Basket is $75.

Step 4: The Share Index on Day 1 is say 100. Now to calculate the Share Index on Day 2, it is: 

ShareIndexDay2 = (BasketDay2 / BasketDay1) * ShareIndexDay1

=  (75/70) * 100.

Step 5: For Day 3, the Share Index price would be: 

(BasketDay3 / BasketDay2) * ShareIndexDay2

= (BasketDay3 / BasketDay2) *  (BasketDay2 / BasketDay1) * ShareIndexDay1

= (BasketDay3 / BasketDay1) * ShareIndexDay1

Step 6: This can be easily generalised to any day in the future. At Day 100, we don't need to calculate the for Day 99, Day 98, Day 97. Instead we can have the simple formula based on Day 1 only. So:

ShareIndexDayN = BasketDayN / BasketDay1 * ShareIndexDay1

The important decisions in creating a Share Index is:

a) Which company stocks to include - which will determine what this Index represents.

b) The proportion of each stock.

c) The Share Index at Day 1. This really does not matter - just pick a nice value here.

 

How to manage a fast-growing basket of Index

This is the case whereby we expect new members to be added on to the index at a fast pace. An example would be a basket of Metaverse altcoins. How do we frequently add to the basket of Index in a fair way.

Suppose we start with 7 stocks.

- At the initial date, assign each stock to have a value of $1. Calculate the units of each stock that would give the value of $1.

- The initial basket value is $7.

- Over time, the basket grows to a value of $120 for example. 

- Add a new stock, such that the new stock holdings is $120/7. Calculate the number of this new stock required.

- On this date when the 8th stock is added, the value of the basket is 120 + 120/7.

With this method, if the basket value is still very low, adding the 8th stock would boost the overall market price.

On the other hand, if there are many stocks in the basket already, adding the next stock would not be significant.

So this caters for a new index which will grow a lot. As the index matures, the total value of the index will grow slower, thus providing stability.