There are thousands of companies listed on stock markets, making it almost impossible to monitor each company. This is why stock market indices are created. Market indices bring together a select group of company stocks and regularly measures them to show the performance of the overall market or a certain segment of the market.
In short, an index helps investors understand the health of the stock market, enables them to study the market sentiment and makes it easy to compare the performance of an individual stock.
The Sensex and Nifty-50 are two popular benchmark indices that largely reflect the performance of Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). To understand how each sector of the stock market is doing, there are sectoral indices such as Nifty Bank. Nifty Auto etc.
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What are Stock Market Index/Indices?
The right guide to understanding a stock market index is to first know what a stock exchange is. The stock exchange is a place where all the tradable securities like shares, bonds, derivatives, commodities are listed.
To be able to trade(buy and sell) these securities, they need to be listed on the stock exchanges first and the Securities and Exchange Board of India (Sebi), our market regulator, oversees such activities.
We have two major stock exchanges in India:
Other than these two we have few other exchanges like Calcutta Stock Exchange, Metropolitan Stock Exchange, National Commodity & Derivatives Exchange Ltd. among others. There are 9 stock exchanges recognized by Sebi in the country.
A stock market index in India is an indicator of its respective stock exchange. Hundreds and thousands of companies are listed on both the exchanges but indicators are a gauge of only a few top-performing companies.
This is done to reduce the clutter and to indicate the true position of the market. Bigger and better companies lead the economy and the country’s financial health hence this is the rationale behind keeping only the cream in the indices. We will later get into the different methodologies of how companies are picked to be listed on the respective indices
Types of Stock Market Indices
Benchmark Indices: S&P BSE Sensex, a collection of 30 best-performing stocks and Nifty 50, a collection of 50 best-performing stocks are indicators of BSE and NSE respectively. They are considered benchmark indices because they are the most concise, use the best practices to regulate the companies they pick and hence are the best points of reference for how the markets are doing in general.
Fun fact: BSE adds S&P as a prefix before all the indices because, in the year 2013, BSE and S&P Down Jones Indices, a global resource for all index related information announced a strategic partnership “to calculate, disseminate, and license the widely followed suite of BSE indices,” BSE had said in a statement. It is just a co-branding technique.
Sectoral Indices: Both exchanges, NSE and BSE also have some indicators that are a gauge of companies falling under one particular sector. Indices like NSE Pharma and S&P BSE Healthcare are indicators of their respective exchanges for the pharmaceutical sector. Another example could be Nifty PSU Bank and S&P BSE PSU Indices are indicators of all the listed public sector banks. It is not necessary that both the exchanges will have corresponding indices for all the sectors but this is generally the case.
Market-cap based indices: There are few indices that purely select companies only on the basis of market capitalization. Market cap, as we know, is the market value of any public traded company. Indices like NSE smallcap 50 and S&P BSE smallcap are indices that are a collection of only those companies that have a lower/smaller market capitalization in accordance with rules by Sebi. There are also other indices like NSE midcap 100, S&P BSE midcap, and likewise.
Other indices: There are also some other indices like S&P BSE 100, S&P BSE 500, NSE 100 among others which are slightly bigger indices and have a much bigger number of stocks listed on them.
WHY DO WE NEED INDICES ?
Indices are an important part of the stock market. Here’s why we need stock indices:
In a share market, there are thousands of companies listed. How do you differentiate between all of those and pick one or two to buy? How do you sort them out? It is a classic case of a pin in a stack of hay. This is where indices come into the picture. Companies and their shares are classified into indices based on key characteristics like size of company, sector or industry they belong to, and so on.
Investor sentiment is a very important aspect of stock market movements. This is because, if sentiment is positive, there will be demand for a stock. This will subsequently lead to a rise in prices. It is very difficult to gauge investor sentiment correctly. Indices help reflect investor’s mood – not just for the overall market, but even sector-wise and across company sizes. You can simply compare an index with a benchmark to see if has underperformed or outperformed. This will, in turn, reflect investor sentiment.
Indices act as a representative of the entire market or a certain segment of the market. In India, the BSE Sensex and the NSE Nifty are considered the benchmark indices. They are considered to represent the overall market performance. Similarly, an index formed of IT stocks is supposed to represent all stocks of companies from the industry.
Many investors prefer to invest in a portfolio of securities that closely resembles an index. This is called passive investment. An index portfolio helps investors cut down cost of research and stock selection. They rely on the index for stock selection. As a result, portfolio returns will match that of the index. For example, if Sensex gave 8% returns in one month, an investor’s portfolio that resembles the Sensex is also likely to give the same amount of returns. Indices are also used to construct mutual funds and exchange-traded funds (ETFs)
An index makes it easy for an investor to compare performance. An index can be used as a benchmark to compare against. For example, in India the Sensex is often used as a benchmark. So, to find if a stock has outperformed the market, you simply compare the price trends of the index and the stock. On the other hand, an index can also be used to compare a set of stocks against a benchmark or another index. For example, on a given day, the benchmark index like Sensex may jump 200 points, but this rally may not extend to a certain segment of stocks like IT. Then, the fall in the value of index representing IT stocks could be used for comparison rather than each individual stocks. This also helps investors identify market trends easily.