Stock market indices or stock market index is statistical tool used to measure the performance of the equity market. It is created by putting a group of stocks as per some pre-defined criteria. The movement of the index depends upon the underlying stocks that the indices hold.
In one way, an index is a statistical tool similar to the sampling method. For example, if we want to find the number of smokers in India among the age group 18 to 35, we won’t ask each and every individual in that age group living in India to take the number. Instead, we will take samples using an appropriate sample size to derive a conclusion that is a more practical and cheap method.
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Why do we need an index?
The purpose of the stock market index is to capture the performance of the overall market. Overall market can be the entire country, sector etc.
Stock market movement is caused by 4 reasons. Either due to stock-specific reasons (New product, fraud activity news about the management etc.), sector-specific reasons (Slow down in the auto industry, Lack of staff in IT industry etc), country-specific reasons (War, Terrorist attacks etc) or due to any other global economy-related news (Pandemic, Economic Recession etc).
The main purpose of any index is to cancel out the influence of any specific stock and to focus on the market as a whole. ie how the country is performing. Index achieves this by averaging and using the weighted method. The common averaging method used is the “weighted averaging method” where more weightage is given to the first stocks in the index compared with the last stocks listed in the index. This helps in cancelling out the impact of the movement of one stock in the index. This makes the index move up and down majorly due to the news that is the whole country, sector or global economy-related. That is why, you see some aggressive movement in the nifty 50 and next 50 indexes and bank index during the 2008 recession, 2000 dot-com bubble and recently 2020 covid.
What are the uses of the stock market index?
An index can be used for many purposes
- To understand the mood and sentiments in the equity market
- To understand the mood and sentiments in the entire economy
- To understand the performance of the government
- To understand the trend of the market
- To understand the performance of a particular sector
- To benchmark the performance on other investment options against the equity
- To benchmark the performance of the mutual fund and their fund managers
- For passive investment
- To track the historical performance of the market for a particular period
Type of stock indices in India
The most commonly used indices in India are Nifty NSE 50 or Sensex (BSE 30). When someone says or when you hear in the news that the market crashed 10% today, it basically means the nifty and Sensex fell 10% today.
Just like this country, indices are not limited to these 2. There are many.
In fact, indices can be classified in many ways
- Based on the exchange – BSE and NSE. As you know Bombay Stock Exchange and National Stock Exchange are the main 2 stock markets in India. So we can find indexes of the same category from these two exchanges. For example, you can find the bank nifty index which is from NSE and BSE Bank Index.
- Based on the broad market – Nifty 50, Nifty next 50, Nifty 100, Nifty 200, Nifty 500
- Based on the sector – Sector-wise index includes Nifty Auto Index, Nifty Bank Index, Nifty Consumer Durables Index, Nifty Financial Services Index, Nifty Financial Services, Nifty FMCG Index, Nifty Healthcare Index, Nifty IT Index, Nifty Media Index, Nifty Metal Index, Nifty Oil & Gas Index, Nifty Pharma Index, Nifty Private Bank Index, Nifty PSU Bank Index, Nifty Realty Index etc.
- Based on market capitalization – Nifty midcap 50, Nifty midcap 100, Nifty small-cap 100 etc
- Based on the theme – Nifty Dividend Opportunities 50, Nifty growth sector 15, Nifty 100 low volatility
How the stocks in the index is selected?
If we take an example, the Nifty 50 index is created using the free-float market capitalisation weighted method. Free float in a layman’s terms is liquidity. A maximum number of transactions of a stock, maximum the liquidity of that stock is. Market capital is derived by multiplying the per-share price with the total outstanding shares in the market.
In general terms, nifty 50 is the largest market capitalized stocks that are traded at high volume in the market. The level of the Nifty 50 Index reflects the total market value of all the stocks in the Nifty 50 Index.
The same principles apply to Sensex aka BSE top 30, but in this case, only the top 30 market capitalized stocks are selected.
Nifty and Sensex move in tandem and the first 30 stocks in nifty and Sensex are the same.
Are all stocks in the index given equal weightage?
Whether it is nifty or SENSEX, stocks in the index are not given equal weightage. In other terms, the weightage of first stocks or highest market capitalized stocks in the index will be higher compared to the ones with low market capitalization. The weightage of the stock comes down as the market cap goes low. Hence, a small change in the price of the first stock in the index will seriously affect the Nifty or Sensex value whereas a change in price in the lowest stock in the index won’t make much difference in the index value.
What kind of averaging is done?
As I already told before, the averaging method used commonly for the stock market index is the “Weighted Average Method”. In this method, each stock in the index is given weightage according to its market capitalisation. For example, if we have 2 stocks in an index and the market cap of stock A is 1000 Crores and Stock B is 2000 Crores, 1/4th of weightage will be given to Stock A and 3/4th weightage will be given to stock B.
What causes ups and downs in a stock market index?
The movement of an index depends upon the buying and selling of stocks included in the index. For example, if sellers are more than buyers for bank stocks due to some macro issues in the Indian banking system, the Bank Nifty index will go down. Also if a stock with heavy weightage in an index is moving up because of sudden positive news in the market, then that particular index also will move up. For example, if the weightage of reliance shares in Nifty 50 is very high, when reliance stock moves up heavily, the nifty 50 index also will move up. So in simple terms movement of an index depends upon the movement of stocks included in that index and its weightage in the index.