Equally Weighted Indexes

Market performance is sometimes measured by an equally weighted average of the returns of each stock in an index. Such an averaging technique, by placing equal weight on each return, corresponds to an implicit portfolio strategy that places equal dollar values on each stock. This is in contrast to both price weighting (which requires equal numbers of shares of each stock) and market value weighting (which requires investments in proportion to outstanding value).

Unlike price- or market-value-weighted indexes, equally weighted indexes do not correspond to buy-and-hold portfolio strategies. Suppose that you start with equal dollar investments in the two stocks of Table 2.3, ABC and XYZ. Because ABC increases in value

CHAPTER 2 Markets and Instruments

Figure 2.12 Performance of stock indexes.

Source: The Wall Street Journal, August 1, 2000. Reprinted by permission of The Wall Street Journal, © 2000 Dow Jones & Company, Inc. All Rights Reserved Worldwide.

by 20% over the year while XYZ decreases by 10%, your portfolio no longer is equally weighted. It is now more heavily invested in ABC. To reset the portfolio to equal weights, you would need to rebalance: sell off some ABC stock and/or purchase more XYZ stock. Such rebalancing would be necessary to align the return on your portfolio with that on the equally weighted index.

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