Stock Market Index – Importance, Need, Types & Selection
The Stock market index or stock index, is a benchmark that measures a particular group of stock, bonds and other investments. It helps investors to estimate performance. Financial institutions and experts around the world use the world indices to describe a stock market and compare the returns on investments by comparing the current stock prices to past prices.
This blog breaks the complex concept into simple explanations. Read on if you are eager to learn more about the stock market index.
What are Stock Market Index/Indices?
The market is changing all the time. A stock index is a statistical measure that reflects this change. To analyse how the stock market is performing, market experts take small groups of stocks from the listed securities in the stock exchange as a sample. This sample is selected based on industry type, market capitalisation or company size. And, it represents the entire stock market and saves analysts from having to study the entire market, which can be time-consuming and complex.
Now, a stock exchange is a place where shares and securities that can be traded are listed. These securities include shares, bonds, derivatives, commodities, etc. The shares and securities should be listed on a stock exchange to be able to conduct buying and selling in the stock market.
Why are Index/Indices Important?
Indices are used across the global markets by financial professionals, institutions, and individuals for the following purposes:
- Stock market indices are the most significant and widely studied parameters in the financial market.
- Investors and traders use the stock market index to analyse the market and manage their investment portfolios.
- Financial institutions use the stock market indices to manage the investment portfolio of clients and draw performance comparisons based on the indices.
- The stock indices indicate the mood and sentiment of the market at a given time. Investors can understand the market’s pattern by looking at the indices and placing profitable buying and selling calls.
- The stock index helps identify the profitable stocks and indicates how these stocks have performed compared to their peers.
- Along with stocks, stock market indices show the trend prevailing in different sectors.
- Investors can make passive investments by analysing the stock indices by choosing index funds that simply mimic the performance of an index.
Also Read: What Is Relative Strength Index (RSI) in Stock Market and How to Calculate it?
What is the Need for Indices in the Stock Market in India?
Indices are are essential in the Indian stock market for the following reasons:
- Grouping and sorting of stocks: Stock market indices make investing and trading easier for investors by grouping the stocks in an organised manner. An index allows the investors to analyse the best stocks together in one place. For example, for the Sensex index, the S&P BSE Sensex is a group of 30 selected Stocks, and S&P BSE is a group of 500 Stocks. Grouping helps the investors see the overall performance of a particular sector without having to study every individual stock from the sector.
- Analysing stock and market performance: Stock market indices help an investor compare the performance of a stock against the benchmark stock in that sector. The index helps in understanding if the stock has been profitable compared to other stocks in the same index or if the stock is riskier than its peers.
Types of Stock Market Indices in India
Benchmark Indices
S&P BSE Sensex is the benchmark index for BSE and Nifty 50 is the index for NSE. S&P BSE Sensex is a collection of the 30 best stocks and the Nifty 50 is a collection of the top 50 stocks. These indices are the benchmark indices because they are the best points of reference due to their concise practices to regulate the selection of companies.
Sectoral Indices
The NSE and BSE exchanges have sectoral indices that analyse the companies lying within a particular sector. For example, S&P BSE Healthcare and NSE Pharma are the pharmaceutical sector indices in BSE and NSE, and Nifty PSU Bank and S&P BSE are indices for the public sector banks. The NSE and BSE may or may not have corresponding indices for every sector.
Market-cap-based Indices
Some indices select companies based only on their market capitalization. The market value of a public traded company is known as the market cap of the company. NSE midcap 100, NSE smallcap 100, S&P BSE midcap, etc., are all examples of market-cap-based indices.
Other Indices
There are several other indices also such as NSE 100, S&P BSE 100, etc., that have higher numbers of stocks listed on them.
What are the Major Stock Exchanges in India?
Two primary stock exchanges in the country are the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). There are thousands of companies listed on the stock exchanges and the stock market indices are the indicators of their respective stock exchanges like the BSE index and the NSE index. These indices do not gauge all the stocks listed on a stock exchange and consider only a few top companies on the index.
1. Bombay Stock Exchange (BSE)
The BSE is India’s oldest stock exchange and was founded by Premchand Roychand in 1857. Financial transactions are made online on BSE on a t+2 rolling settlement through an electronic trading system. This means that trades made on a certain day are settled after 2 days.
BSE is regulated by the Securities and Exchange Board of India (SEBI), which ensures the implementation of rules and regulations for the smooth operation of BSE.
2. National Stock Exchange (NSE)
Founded in 1922, the NSE is the leading stock exchange in India, and boasts of an advanced electronic trading platform for investors in India. NSE has revolutionised stock trading in India by becoming the first stock exchange to introduce the electronic trading of stocks in the country.
How are Stocks Selected in an Index?
The rise or fall of the stock index shows the overall performance of the stocks listed on that particular index. The stocks in an index are picked based on the following two factors:
Market Capitalisation
When the stocks are picked and grouped based on their market capitalisation, the companies with the largest market cap are grouped.
Price
Some world indices select stocks in the indices based on their price. Companies with a higher stock price affect the indices more than the stocks with a lower value.
Major Stock Market Indices in India
What is Sensex?
One of the most popularly used terms in the stock market, Sensex was penned down by market expert Deepak Mohoni. Sensex meaning is a combination of two words – sensitive and index. Sensex India comprises 30 of the largest and most-traded stocks on the BSE, compiling stocks from some of the largest companies in the country. The BSE Sensex is the pulse of the Indian stock market and was first published on 1st January 1986.
How is Sensex Calculated?
The value of Sensex is calculated by applying the free-flow method. The free-flow method of calculating Sensex takes into consideration the shares that can be readily traded. The market capitalisation of all the 30 companies whose stocks are traded is calculated, which gives the free-float factor of BSE. It helps in calculating the free-float market capitalisation, after which ratio and proportion are used to give the value of the Sensex, for a base index of 100. The formula for it is:
Sensex = (Total free float market capitalization/Base market capitalization) X Base Index Value
Points to Remember Before Choosing an Index or Index Fund
Before selecting an Index Fund, an investor needs to consider the following points:
- Index funds are not zero-risk investments and are subject to the same market highs and lows as other funds in the market.
- Index funds have a higher chance of matching the performance of large-cap funds.
- Due to tracking errors, there is a minor difference in the returns of Index funds and the Index itself.
- Index funds may or may not be cheap, and some index funds may have a high expense ratio, taking away the cost-saving purpose of the fund. Index funds are taxed in the same way as equity funds.
Also Read: What is EPS in Stocks and Why is it Important?
Final Word
Stock market indices are a necessity today and save investors from having to hunt headlessly for good stocks to invest. The stock index makes stock market investment easy for investors and financial institutions by reducing the initial load of the investors. However, investors need to assess their risk profile and make their investment portfolios.
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FAQs on Stock Market Index
Ans: Two major stock exchanges in India are the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE).
Ans: The word Sensex is made from two words, sensitive and index. The Indian Sensex consists of the 30 most traded stocks on the BSE.
Ans: The formula to calculate Sensex is:
Sensex = (Total free-float market capitalisation/Base market capitalization) X Base Index Value
Ans: The stocks are selected in an index based on market capitalisation and price.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
