Stock Market Indices provide insight into the overall trends of the capital markets and investor sentiment toward a specific stock or set of stocks in an industry.
What is an Index?
A stock market index, also known as a stock index, is a statistical measure that reflects market changes. It is created by grouping a few similar stocks from the securities listed on the exchange. The selection criteria could be a company’s size, market capitalization, or industry type. The index’s overall value is affected by changes in the prices of its underlying securities. If prices rise, the index rises; if prices fall, the index falls.
Types of Indices in the Indian Stock Market
The following are some of the most common types of indices in the Indian stock market:
- Benchmark indices such as the BSE Sensex and the NSE Nifty
- Broad-based indices such as the Nifty 50 and the BSE 100
- Indexes based on market capitalization, such as the BSE Midcap and BSE Smallcap
- Sectoral indices include the CNX IT, Nifty FMCG, Nifty Bank Index, and S&P BSE Oil and Gas.
Other indices in the Indian stock market include thematic indices, which reflect the performance of broad-based investment themes.
Why do we need Indices?
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.
- Assists 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 Attitude
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.
- 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 Selection
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.
How are stock market indices developed?
An index comprises similar stocks in market capitalization, industry, or company size. The index value is calculated after selecting stocks. However, each stock will have a different price, and a change in one stock’s price will not be proportionately equal to another’s price. As a result, the index value cannot be calculated by adding the prices of all the stocks.
This is where the importance of stock weighting comes into play. The weightage of each stock in the index is determined by its market capitalization or price. The weight represents the magnitude of a stock’s price change’s impact on the index’s value.
The two most commonly used methods to categorize stock market indices are as follows:
- Price weightage
The value of an index is computed using this method based on a company’s stock price rather than its market capitalization. As a result, stocks with higher prices receive greater weight in the index than stocks with lower prices. The Dow Jones Industrial Average in the United States and the Nikkei 225 in Japan have used this method.
- Market-cap weightage
The total market value of a company’s stock is referred to as its market capitalization. It is calculated by multiplying the total number of outstanding stocks issued by the company by the stock’s share price. As a result, it considers both the price and the size of the stock. In a market-cap-weighted index, stocks are assigned weightage based on their market capitalization relative to the index’s total market capitalization.
It is important to note that the market capitalization of stock changes daily due to price fluctuations. As a result, the stock’s weightage would change daily. However, such a change is usually minor. Furthermore, this method gives companies with larger market capitalizations more weight.