What is a Market Index?
Stock market indices track ups and downs of group of stocks or other assets. Stock market index reflects the health or sentiment of stock market. To read further about market index, first lets read about stock exchange.
A stock exchange is a platform where shares are traded. But to be traded on stock exchange, company has to be listed on it. Stock exchange is a meeting place of stock buyer and seller. Bonds, Shares, Derivatives, Mutual Fund are traded in stock market. There are 9 active stock exchanges in India but Bombay Stock Exchange(BSE) and National Stock Exchange(NSE) are major stock exchanges in India.
Thousands of companies are listed on stock market exchanges. From these listed stocks, few stocks are selected and grouped together to form an index. The selection of stocks are done on the basis of particular industry, sector, size of the company, market capitalization or some other basis. For example, the BSE Sensex is an index consisting of 30 stocks. Similarly, the BSE 500 is an index consisting of 500 stocks.
The value of index is calculated using the value of chosen stocks. If the value of any stock changes, the value of index will also change. Market index shows the direction of movement of financial market, stock market, commodity market or any other market. Basically, index tracks the performance of certain group of stocks, bonds or other investment.
What are the types of market indices?
- Benchmark Indices: NSE Nifty shows collection of 50 best performing stocks in NSE and BSE Sensex shows collection of 30 best performing stock in BSE. These benchmarks are considered as benchmarks as they can be the best reference to show how market is performing.
- Broad-based Indices: Indices like S&P BSE 100, S&P BSE 500, NSE 100 are bigger indices and a big number of stocks are grouped to make these indices.
- Market Capitalization Indices: These indices select group of companies on the basis of market capitalization. Market capitalization is the worth of a company that is traded in stock exchange. Indices like the BSE Smallcap and NSE Smallcap 50 are indices which shows group companies with low market capitalization. BSE midcap and NSE midcap indicates group of companies with medium market capitalization.
- Sectoral Indices: Indices like NSE Pharma and S&P BSE Healthcare are indicator of pharma companies listed on NSE and BSE. Nifty PSU Bank and S&P BSE PSU indices are indicators of all the listed public sector banks. Nifty FMCG Index and CNX IT are few more examples.
An index is a group of similar stocks. The selection is done on the basis of industry, company size, market capitalization or another parameter. When the value of index goes up, it means that all stocks which are grouped in an index are performing well. If any stock goes 5% up but that does not mean that the index will also go up as there are other stocks too in index which may have also gone up or down. How the value of index calculated? The index value cannot be a simple total of the prices of all the stocks. Once the stocks are selected, it has to be determined how these stocks are represented in an index. And here the concept of stock weightage comes.
Each stock in an index has a particular weightage depending on its price or market capitalization. This is the amount of impact a change in the stock’s price has on index value.
The two most common kinds to select stocks are Price-weighted and Market capitalization-weighted index.
- Market-cap Weightage: Market capitalization is the worth of a company that is traded in stock exchange. So, it is the multiplication of total number of shares and current market price of one share. In an index which uses market-cap weightage, stocks are given weightage on the basis of their market capitalization.
Stocks with largest m-cap are grouped. Stocks with large m-caps have bigger weightage than stocks with small m-caps. So this method takes into consideration both the size and the price of the stock. Market capitalization changes everyday due to change in price of the stock. So, the weightage of stock changes in index.
In India, free-float market capitalization method is generally used to assign weightage to stocks. In this method, it uses shares which are publicly available for trading. It means, it doesn’t include shares held by promoters.
- Price Weightage: As the name suggests, company’s stock price is considered instead of market capitalization to calculate price of index. Stocks with higher prices have bigger weightages in the index than stocks with lower prices. Few examples of price-weighted indices are Dow Jones Industrial Average in the US and the Nikkei 225 in Japan.
Why do we need indices?
There are thousands of companies listed on stocks exchange. Investor does not know where to invest, which stocks have higher m-cap value or which stocks are performing better. Market indices help investors to pick up stocks as market indices represent a group of selected stocks and the selection is done on basis of size of company, sector or industry they belong to, and so on. Following are few reasons why market indices are needed:
- Grouping and sorting: As written above, stocks are selected and grouped with certain strategy to make an index. Like, free-float market cap method selects best of stocks. For example, BSE Sensex shows collection of 30 best performing stock in BSE. S&P BSE 100 is a collection of 100 stocks and S&P BSE 500 is a collection of 500 stocks. So, these indices help investor to select the top stocks.
You can also check how one particular sector is performing. For example, if someone wants to check how IT sector is performing then in absence of sector index, investor has to find all IT stocks and do some math to calculate the performance. But, indices NIFTY IT, BSE IT make it easier.
- Representation: Market index is not only helpful to select the top stocks but it represents the market or sectors also. Like, BSE Sensex and NSE Nifty are benchmark indices which represent how overall market is performing. Investor can also find if stock is performing better than benchmark stock market index and how one stock is performing in comparison with other stocks in same sector. Like, if price of stock is increasing by 4% but the benchmark index is increasing by 10% then we can say that stock is under performing its benchmark index. Also, we can compare the stocks with other stocks too using index.
- Reflection of sentiment: Investor’s sentiments play important role in stock market. It means, if sentiment is positive, demand will be more. And if demand is more then stock prices go up. So, market indices reflect sentiments of investor.
- Passive investment: Many investors follow one particular market index and purchase stocks which make that index. This type of investment is known as passive investment. It saves cost of research and stock selection. Performance of investor’s investment goes hand in hand with market index with which investor has resembled his stock selection. Mutual funds like Index mutual fund and exchange-traded funds (ETFs) use market indices.