What is an index in the stock market?

If you want to assess the overall performance of the stock market, it can be very challenging to maintain track of every stock. As a result, the performance of the entire market is sampled using a limited number of stocks.

This specimen set of stocks collectively is referred to as an index. The price of the stocks chosen for the sample is used to determine this index’s value. A statistical measure that captures market fluctuations is a stock market index, commonly known as a stock index. The securities listed on the exchange are grouped together with a few related stocks, and the selection criteria may include a company’s size, market capitalization, or industry.

The overall value of the index is impacted by changes in the prices of the underlying securities. The index will increase if the majority of the stocks prices increase, and the index will decrease if the majority of the stocks prices decrease.

In India, there are two main stock exchanges: National Stock Exchange (NSE) Bombay Stock Exchange (BSE)

Types of Stock Market Indices

Benchmark Indices:

The benchmark indices for the BSE is the BSE Sensex, which is made up of the 30 stocks selected according to their market capitalisation and the sector they represent, and NSE are the Nifty 50, which is made up of the 50 stocks based on their market capitalisation and sectors.. These are regarded as benchmark indexes because they are the most brief, represent the companies they choose using the best statistical methods, and are thus the most effective indicators of how the markets are performing generally.

Sectoral Indices:

The NSE and BSE both have a few indicators that serve as a barometer for businesses in a specific industry. Indices for their respective exchanges’ pharmaceutical sectors include NSE Pharma and S&P BSE Healthcare. Nifty PSU Bank and S&P BSE PSU could serve as further examples of indices representing the PSU bank sector. Not all sectors will necessarily have matching indexes on both exchanges.

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Indices based on market capitalization:

There are indices that choose firms solely based on their market capitalization. We all know that a company’s market capitalization represents its current market value. According to Sebi regulations, only those businesses with a lower/smaller market capitalization are included in indices like NSE smallcap 50 and S&P BSE smallcap. Other indices exist as well, such the NSE Midcap 100, S&P BSE Midcap, and others.

Other Indices:

There are also several more indexes, such the S&P BSE 100, S&P BSE 500, and NSE 100, which are a little bit bigger indices and have a lot more stocks listed on them. Some famous indices which represent the stocks listed in foreign countries are Dow Jones, SGX Nifty, Nasdaq100, S&P 500.

How Are Stocks Selected by Indices?

By now, we have understood that indices serve as a technique of grouping the most suitable stocks since they have the greatest economic impact and serve as the best indicator for understanding the markets as a whole. But we also need to understand how an Indian stock market index chooses stocks.

The selection of stocks is mostly based on two factors:

a)  Market-capitalization:

When the Market-capitalization is the foundation of the stock selection approach, the largest market-cap companies are chosen and put together in an index. Companies with the highest m-cap have a greater impact on the index’s value, whilst stocks with low m-cap have less of an impact. Most Indian indices weigh their stocks according to free-float market capitalisation.

What distinguishes free float m-cap from complete m-cap: The company’s market capitalization, or M-cap, is determined by the value of all of its issued and outstanding shares. Shares held by promoters are not included in the free float m-cap, which is used by the indices to weigh stocks.

Reliance Industries Ltd. (RIL), for instance, has the greatest free float m-cap and hence has the highest weightage among the other stocks that make up the Sensex. Therefore, a change in RIL, whether positive or negative, will have a greater effect than a change in other stocks, whether positive or negative.

b)  Price:

Some indices in the world also use price to determine how much weight to assign to individual equities. Japan’s Nikkei 225 is a prime illustration of this. Companies with higher stock prices are weighted more heavily and have a greater impact on the index than lower priced stocks.

Why Is It Important to Have Stock Market Indices?

The performance of market indices serves as a very reliable indicator of the status of the markets and captures the mindset of investors as a whole.

Benchmarking: Many traders, investors, and other market participants use the performance of the indices as a benchmark to evaluate their stock market investments. In order to compare

the real performance of the stocks in your investment portfolio with that of NIFTY over a specific time period, you can utilise NIFTY’s performance over the same time period.

Help for Passive Investors: Choosing the best stocks to invest needs extensive research. For passive investors, who seek long-term investment opportunities without actively managing their portfolio all the time, these indices prove to be very helpful for them as they can invest in index funds which replicate the indices

Provides Diversification in Portfolio: Investing in index funds is one approach to match the market performance while reducing your risk. Index funds have a reduced risk of underperformance since they include equities from several sectors and businesses, effectively diversifying your investment portfolio. Your corpus may be diminished if you invest in particular stocks that perform poorly. However, your risk exposure is significantly decreased by using stock market indices.

Stock market indexes are incredibly helpful and serve as a an indicator of market performance as well as protection for cautious investors during periods of market turbulence. If you’re new to the equity markets, it can be a good idea to start by studying market indices and analysing to obtain a better understanding of how the markets actually operate.

 

About the Author

Ketan Sonalkar (SEBI Rgn No INA000011255)

Ketan Sonalkar is a certified SEBI registered investment advisor and head of research at Univest. He is one of the finest financial trainers, with a track record of having trained more than 2000 people in offline and online models. He serves as a consultant advisor to leading fintech and financial data firms. He has over 15 years of working experience in the finance field. He runs Advisory Services for Direct Equities and Personal Finance Transformation.

Note – This channel is for educational and training purpose only & any stock mentioned here should not be taken as a tip/recommendation/advice

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