You are standing in the middle of a crowded marketplace, where traders are constantly buying and selling. But the question here is how do you keep track of the overall mood of the market—whether it is rising or falling? That is where a stock market index comes in. It acts like a thermostat for the stock market, measuring its health and direction. In simple terms, a stock market index tracks the performance of a selected group of stocks.But how does it actually work, and why is it so important? Let’s dive into the details and uncover the basics of stock market indices.
What is a Stock Market Index?
A stock market index serves as a statistical indicator that tracks the overall performance of a specific group of stocks. It represents a market segment, such as an industry or the broader market, with values based on its constituent stock prices, weighted by factors like market cap or price.
They help investors and fund managers identify market trends, facilitating smarter investment decisions. Additionally, these indices are fundamental in developing index funds and ETFs, which aim to replicate a specific index’s performance.
Major Indian Stock Market Indices
As rich as the history of stock exchange, the two major indices in the stock market trading are Sensex and Nifty 50.
BSE Sensex
Acknowledged as the S&P BSE Sensex, the BSE Sensex is India’s benchmark index for the Bombay Stock Exchange (BSE). It was first launched on January 1, 1986, and became a key indicator of Indian stock market performance. The name “Sensex” is short for “Sensitive Index,” coined by market analyst Deepak Mohoni in 1989.
The Sensex has 30 of the largest and most actively traded companies on the BSE from different sectors of the Indian economy. These companies are chosen based on trading activity, liquidity, and sector representation. The index uses the free-float market capitalisation method to consider only shares available for trading and to mirror real market trends and investor sentiment. That means insider or promoter holdings are excluded.
The Sensex’s importance lies in its function as an economic indicator for India. It provides information about market trends and investor sentiment, making it a key instrument for investors, analysts, and policymakers. Over the years, the Sensex has reached significant milestones, such as hitting the 10,000 mark in 2006 and the 40,000 mark in 2019, and as of October 2024, it is over the 80,000 mark.
NSE Nifty 50
The Nifty 50 is India’s leading National Stock Exchange (NSE) index. Established on April 22, 1996, it is managed by the NSE Indices Limited, a wholly-owned subsidiary of the NSE.
The Nifty 50 includes 50 of the NSE’s biggest and most actively traded companies. It covers 13 sectors of the country’s economy and is selected based on market capitalisation, liquidity, and trading volume. Like the Sensex, the index is calculated using the free-float market capitalisation method.
The Nifty 50 holds considerable importance for multiple reasons. It accounts for roughly 56% of the free-float market capitalisation of NSE-listed stocks. The index is commonly utilised for benchmarking fund portfolios, index-based derivatives, and index funds. Investors, analysts, and policymakers closely monitor its performance as it offers critical insights into the health of the Indian economy and investor sentiment.
Other Notable Indices
- Nifty Next 50: This index comprises the 50 companies that follow the Nifty 50 in market capitalisation and liquidity. It acts as a benchmark for mid-cap stocks. The Nifty Next 50 is often viewed as a way for companies aiming to join the Nifty 50.
- BSE Midcap: The BSE Midcap index tracks the performance of mid-sized firms listed on the BSE. It features companies that exceed small-cap stocks but are smaller than the large-cap stocks in the Sensex.
How is the Index Computed?
There are many methods to compute the index; the common ones are:
Equal-Weighted Index Calculation
To determine the index value for an equal-weighted index, add the prices of all stocks and divide by the total number of stocks. This method treats each stock equally. For example, if three stocks are priced at ₹100, ₹300, and ₹500, the index value is calculated as follows:
- Index Value=(100 + 300 + 500) ፥ 3
- Index Value =300
Market-Cap Weighted Index Calculation
For a market-cap-weighted index, multiply each stock’s price by its corresponding market capitalisation. Next, add these values and divide by the total market cap of all stocks. For example, if Stock A is at ₹100 and has a market cap of ₹1,00,000 crore, and Stock B is at ₹50 with a market cap of ₹50,000 crore, the index calculation would be:
- Index Value = {(100 × 1,00,000) + (50 × 50,000)} ፥ (1,00,000 + 50,000)
- Index Value = (1,00,00,000 + 25,00,000) ፥ 1,50,000
- Index Value = 83.33
Price-Weighted Index Calculation
To find a price-weighted index, add the prices of all the stocks and divide by how many stocks there are. For instance, if an index includes three stocks priced at ₹100, ₹200, and ₹300, the index value would be:
= (100 + 200 + 300) / 3 = 200.
Advantages of Stock Market Index
The stock market indices are advantageous in many ways:
1. Simplifies Market Analysis
Instead of looking at each stock, you can rely on stock indices like the Nifty 50, which tracks the top companies on the NSE, to give a quick idea of how the market is doing.
2. Helps in Diversification
Indices support diversification by covering multiple market segments. For example, the Sensex, which tracks 30 top companies, helps investors limit risk by distributing it across various industries, minimising the impact of a single stock’s decline.
3. Provides a Benchmark for Performance
Indices function as reference points for measuring the performance of individual stocks or portfolios. Mutual funds, for instance, often use the Nifty 50 to evaluate their returns, helping investors determine if their investments are beating the market.
Limitations of Stock Market Index
The stock market indices are not without downsides. Here are some:
1. May Not Represent the Entire Market
While indices such as the Nifty 50 and Sensex offer a market overview, they primarily reflect large-cap stocks, leaving out mid-cap and small-cap stocks, which can also have a substantial impact.
2. Can Be Influenced by a Few Large Companies
Companies with larger market caps, like Reliance Industries or TCS, can significantly affect indices like the Nifty 50, sometimes causing the overall market outlook to be skewed.
3. Potential for Misinterpretation
Investors may mistakenly believe that index movements represent the whole market. For instance, a Sensex increase could be driven by a few large companies while the rest of the market struggles, potentially leading to poor investment choices.
How to Invest in the Stock Market Index?
There are two ways to invest online in the index. These are:
Direct Investment
A simple way to invest in stock market indices through the Indian stock market app is by using index funds or Exchange-Traded Funds (ETFs). These funds mirror the performance of indices like the Nifty 50 or S&P 500. Buying shares in them exposes you to all companies in the index, offering broad diversification, low costs, and ease of use.
Indirect Investment:
As mentioned, stock market indices can also serve as a reference point for selecting individual stocks. You can spot trends and choose stocks by analysing how various indices perform. For example, if the Nifty 50 is thriving, buying stocks of its top-performing companies could be beneficial.
Conclusion
A stock market index is essential for understanding the stock market’s performance. It provides a snapshot of how specific groups of stocks are performing to help investors track trends. Whether you are a passive investor using index funds or an active trader comparing your portfolio’s performance to an index, understanding how indices work is key to navigating the world of investments. However, while indices provide valuable insights, it is crucial to be aware of their limitations and use them alongside other tools and strategies for a more comprehensive investment approach.
Now that you know the index, open Demat account with HDFC SKY and start stock trading using the HDFC Sky App to benefit from the snapshot the Sensex and Nifty provide.
