A stock market index is a statistical measure that depicts changes in the stock market. To create an index, a few similar types of stocks are selected and grouped together from among the securities already listed on the exchange.
The type of industry, market capitalisation, or company size could all be stock selection criteria. The underlying stock values are used to calculate the value of the stock market index. Any changes in the underlying stock prices have an impact on the index’s overall value. If the prices of the majority of the underlying securities rise, so will the index, and vice versa.
Why are stock indices required?
The stock market index functions as a barometer, indicating the overall state of the market. They assist investors in identifying the general market pattern. In addition, the stock market is used by investors to determine which stocks to invest in.
The importance of stock market indexes is listed below:
- Helps in Passive Investment
Investing in a portfolio of securities replicating an index’s stocks is called passive investment. Investors who want to save money on research and stock selection prefer to invest in index funds. As a result, the portfolio’s returns will be similar to those of the index. For example, if an investor’s portfolio resembles the Sensex, his portfolio will deliver 8% returns when the Sensex earns 8% returns.
- Reflects Investor Sentiment
Knowing investor sentiment becomes important when participating in equity markets, among other things. Because sentiment influences demand for a stock, which in turn influences the overall price. To invest in the right stock, you must first understand why its price has risen or fallen. At this point, indices can help investors gauge their mood. You may even notice differences in investor sentiment across sectors and market capitalizations.
- The Parameter for Peer Comparison
Before you add a stock to your portfolio, you must determine whether it is worth the investment. A stock’s performance can be easily judged by comparing it to the underlying index. If a stock outperforms the index, it is said to have outperformed the index. Conversely, it is said to have underperformed the index if it produces lower returns than the index.
You should definitely invest in a multi-bagger to justify the risk you are taking. Otherwise, low-cost, professionally managed index funds may be a better option. You can also compare the index to a group of stocks, such as those in the information technology sector. As an investor, you can easily identify market trends.
- Acts as a Representative
Investing in equities entails risk, and you must make an educated decision. Individual stock research may be impractical. Indices assist in filling knowledge gaps among investors. They represent the overall market trend or a specific market sector. The benchmark indices in India are the NSE Nifty and the BSE Sensex. They are thought to reflect the overall performance of the stock market. Similarly, an index composed of pharmaceutical stocks is assumed to represent the average price of stocks of pharmaceutical companies.
- Aids in Stock-Picking
A stock exchange would have thousands of companies listed on it. Choosing the right stock for investment may appear to be a nightmare. With a benchmark, you may be able to distinguish between stocks. However, sorting the stocks at the same time becomes difficult. A stock market acts as an instant differentiator in this situation. It categorizes companies and their shares based on key characteristics such as company size, sector, industry type, etc.
