Make a tiny index

Watch the three steps.

An index is worked out from the prices of the stocks in it. Here's the simplest kind, with just three stocks.

Add the prices, then divide by a number called the **divisor**. The divisor is chosen so the index starts at a round number, here **1,000 points**. From now on, the index moves whenever the prices move.

Move the prices

Change each stock's price and watch the index.

Start: A ₹100, B ₹200, C ₹300, index 1,000. Move each price up or down.

**Remember:** in this simple kind of index, a high-priced stock moves the index more than a low-priced one, even for the same % move.

Points, not rupees

The index's starting number is just a choice. The divisor could have made it 100 or 10,000 instead of 1,000. That's why an index is measured in **points**, not rupees.

• What matters — How much the index **changes**: 1,000 to 1,100 is a 10% rise, whatever the starting number.
• What doesn't — The size of the number itself. A 20,000-point index isn't "bigger" or better than a 1,000-point one.

When a stock leaves the index

Switch between the two ways.

Stocks must meet rules to stay in an index. If one stops meeting them, it's **replaced**. But swapping stocks changes the total, so something else has to change too.

**Remember:** the divisor changes only when the list of stocks changes, so the index never jumps for no real reason.

Two ways to build an index

• Price-weighted add the prices — What you just built. The highest-priced stocks count most. A few famous US and Japanese indices work this way.
• Value-weighted add the companies' values — Each company counts by how much it's worth in the market. The Sensex and Nifty work this way.

Next lesson: how value weighting works, and why big companies move the Sensex and Nifty most.

What you now know

• An index is worked out from the prices of the stocks in it.
• Simplest kind: add the prices, then divide by a divisor.
• The divisor sets the starting level; that's why indices are in points.
• Judge an index by its % change, not by the size of its number.
• When a stock is replaced, the divisor changes so the index doesn't jump.
• Price-weighted indices favour high-priced stocks; the Sensex and Nifty are value-weighted.