Stock market indices
Stock market indices: A stock market index is a statistical measure that 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 capitalization or the size of the company.
The value of the stock market index is computed using the values of the underlying stocks. Any change taking place in the underlying stock prices impacts 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
The stock market index acts like a barometer that 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 which stocks to go for investing.
The following lists the importance of the 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 the 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 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 and 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 that 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 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 multi-bagger 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 that replicate the stocks of an index. Investors who want to cut down on the cost of research and stock selection prefer to invest in an 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 development
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 that 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 the market capitalization of stock changes every day with the fluctuation in its price. Due to this reason, the 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 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 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 weights 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.