A stock market index is a statistical measure which shows changes taking place in the stock market. To create an index, a few similar kinds of stocks are chosen from amongst the securities already listed on the exchange and grouped together.
The criteria of stock selection could be the type of industry, market capitalisation or the size of the company. The value of the stock market index is computed using values of the underlying stocks. Any change taking place in the underlying stock prices impact the overall value of the index. If the prices of most of the underlying securities rise, then the index will rise and vice-versa.
In this way, a stock index reflects overall market sentiment and direction of price movements of products in the financial, commodities or any other markets.
Some of the notable indices in India are as follows:
- Benchmark indices like NSE Nifty and BSE Sensex
- Broad-based indices like Nifty 50 and BSE 100
- Indices based on market capitalization like the BSE Smallcap and BSE Midcap
- Sectoral indices like Nifty FMCG Index and CNX IT
Why are stock indices required?
The stock market index acts like a barometer which shows the overall conditions of the market. They facilitate the investors in identifying the general pattern of the market. Investors take the stock market as a reference to decide about which stocks to go for investing.
The following lists the importance of stock market index:
a. Aids in Stock-Picking
In a share market, you would thousands of companies listed on the exchange. Broadly, picking the appropriate stock for investment may seem like a nightmare. Without a benchmark, you may not be able to differentiate between the stocks. Simultaneously sorting the stocks becomes a challenge. In this situation, a stock market acts like an instant differentiator. It classifies the companies and their shares based on key characteristics like the size of company, sector, industry type and so on.
b. Acts as a Representative
Investing in equities involves risk and you need to take an informed decision. Studying about stocks individually may seem very impractical. Indices help to fill the knowledge gaps that exist among the investors. They represent the trend of the whole market or a certain sector of the market. In India, the NSE Nifty the BSE Sensex act as the benchmark indices. They are believed to indicate the performance of the entire stock market. In the same manner, an index which is made up of pharma stocks is assumed to portray the average price of stocks of companies operating in the pharmaceutical industry.
c. The Parameter for Peer Comparison
Before including a stock in your portfolio, you have to assess whether it’s worth the money. By comparing with the underlying index, you can easily judge the performance of a stock. If the stock gives higher returns than the index, it’s said to have outperformed the index. If it gives lower returns than the index, it’s said to have underperformed the index.
You would definitely want to invest in a multibagger so as to justify the risk assumed. Else you can be better off investing in low-cost professionally managed index funds. You may also compare the index with a set of stocks like the Information technology sector. As an investor, you can know market trends easily.
d. Reflects Investor Sentiment
When you are participating in equity markets, amongst other things, knowing investor sentiment becomes an important aspect. It is because the sentiment affects the demand for a stock which in turn impacts the overall price. In order to invest in the right stock, you should know the reason behind the rise/fall in its prices. At this juncture, indices help to gauge the mood of investors. You may even recognize investor sentiment for a particular sector and across market capitalizations.
e. Helps in Passive Investment
Passive investment refers to investing in a portfolio of securities which replicates the stocks of an index. Investors who want to cut down on the cost of research and stock selection prefer to invest in index portfolio. Consequently, the returns of the portfolio will resemble that of the index. If an investor’s portfolio resembles the Sensex, then his portfolio is going to deliver returns of around 8% when the Sensex earns 8% returns.
How are stock market indices developed?
An index is made up of similar stocks based on market capitalization, industry or company size. Upon selection of stocks, the index value is computed. Each stock will have a different price and price change in one stock would not be proportionately equal to the price change in another. So, the value of the index value cannot be arrived at as a simple sum of the prices of all the stocks.
Here is when the importance of assigning weights to stocks comes into play. Each stock in the index is assigned a particular weightage based on its market capitalization or price. The weight represents the extent of the impact that the stock’s price change has on the value of the index.
The two most commonly used stock market indices are as follows:
a. Market-cap weightage
Market capitalization refers to the total market value of the stock of a company. It is calculated by multiplying the total number of outstanding stocks floated by the company with the share price of a stock. It, therefore, considers both the price as well as the size of the stock. In an index which uses market-cap weightage, the stocks are assigned weightage based on their market capitalization as compared to the total market capitalization of the index.
Suppose a stock has a market capitalization of Rs. 50,000 whereas the underlying index has a total market-cap of Rs. 1,00,000. Thus, the weightage given to the stock will be 50%.
It is important to note that market capitalization of a stock changes every day with the fluctuation in its price. Due to this reason, weightage of the stock would change daily. But usually such a change is marginal in nature. Moreover, the companies with higher market-caps get more importance in this method.
In India, free-float market capitalization is used by most of the indices. Here, the total number of shares listed by a company is not used to compute market capitalization. Instead, use only the amount of shares available for trading publicly. Consequently, it gives a smaller number than the market capitalization.
b. Price weightage
In this method, the value of an index value is computed based on the stock price of a company rather than the market capitalization. Thus, the stocks which have higher prices receive greater weightages in the index as compared to the stocks which have lower prices. This method has been used in The Dow Jones Industrial Average in the US and the Nikkei 225 in Japan.
What is NSE & BSE?
Started in 1994, the National Stock Exchange (NSE) is the largest stock exchange in India in terms of total and average daily turnover for equity shares. Being a pioneer in technology, NSE has a fully-integrated business model to provide high-quality data and services to market participants and clients. It includes trading services, exchange listings, indices, market data feeds, clearing and settlement services, financial education offerings and technology solutions. NSE ensures that trading and clearing members and listed companies follow the rules and regulations of the exchange.
Founded in 1875, Bombay Stock Exchange Ltd. (BSE), is the fastest stock exchange in the world which has the speed of 6 microseconds. It provides an efficient, integrated, transparent and secure market for trading in equity, currencies, debt instruments, derivatives, mutual funds. It provides an array of services like clearing, settlement, risk management, education and market data services. It has a global reach with overseas customers and a nation-wide presence. It provides depository services through its Central Depository Services Ltd. (CDSL) arm. The S&P BSE SENSEX is India’s most widely tracked stock market benchmark index. It is traded internationally on the EUREX as well as leading exchanges of the BRICS nations (Brazil, Russia, China and South Africa).