Using Index for Investing

Investing using benchmark indices like Nifty 50, Sensex, S&P 500 etc. is quite popular as it makes quite easier to manage investments.

Learning Tip

A benchmark is a standard or measure that can be used to analyze the allocation, risk, and return of a given portfolio. A variety of benchmarks can also be used to understand how a portfolio is performing against various market segments.

Understanding

Benchmark Index

Investors often use the Nifty 50 index as an equity performance benchmark since it is most popular among all the major benchmark indices. However, there are many types of benchmarks that investors can use, depending on the investments, risk tolerance, and time horizon.

Benchmarks include a portfolio of unmanaged securities representing a designated market segment. Institutions manage these portfolios known as indices.

Some of the most common institutions known for index management are NSE for Nifty 50, BSE for Sensex, Standard & Poor’s (S&P) and MSCI.

Many mutual funds in the investment industry use index as the base for a replication strategy. Mutual funds contain pool of investment funds that are actively managed by portfolio managers and invested in various securities, such as stocks, bonds, and money market instruments.

The evolution of ETFs has brought about the introduction of smart beta indexes, which offer customized indices that rival the capabilities of active managers.

Smart beta indices use advanced methodologies and a rules-based system for selecting investments to be held in a portfolio. Smart beta funds represent essentially the middle ground between a mutual fund and an ETF.

Now you have basic understanding of benchmarks. Let’s see how to use them in portfolio management.

Risk Management

Using Index in Portfolio

Most people invest in a diversified portfolio that includes numerous asset classes, generally using equities and bonds. Risk metrics can be used to help understand the risks of these investments. Risk is most often characterized using variability and volatility.

The size of the change in portfolio value measures volatility. Investment funds that contain commodities, which have larger moves up and down in value, have an increased amount of volatility.

Variability, on the other hand, measures the frequency of the change in value. Overall, the more variability, the greater the risk.

Here are few factors to focus on for portfolio management using index:

Standard deviation is a statistical measure of volatility by calculating the variance in price moves of an investment to the mean or average return over a period. A higher standard deviation indicates more volatility and greater risk.

Beta is used to measure volatility against a benchmark. For example, a portfolio with a beta of 1.2 is expected to move 120%, up or down, for every change in the benchmark.

A portfolio with a lower beta would be expected to have less up and down movement than the benchmark. Beta is usually calculated with the S&P 500 or Nifty 50 as the benchmark depending on your country.

Risk is a central component of all investing decisions. By simply using the performance and risk metrics of an index in comparison to investments, an investor can better understand how to allocate their investments most prudently.