Want to demystify the stock market? Start with understanding the term ‘index.’ An index is a snapshot of the stock market, tracking selected stocks to gauge overall market performance. It’s a unit of measurement that investors use to follow the progress of specific asset sets and is a reflection of the prices of various securities. Indices can be general or industry-specific, like the Nifty Pharma Index or Nifty Midcap 150, all of which track a range of companies across multiple sectors. This article will break down the basics of indices, their role in evaluating investment portfolios, and popular indices around the world, simplifying this key stock market concept for novice investors.
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What is an index?
In simple terms, an index is a unit of statistical measurement used in the stock market. It helps in monitoring any changes in the stock market. You can use an index to track the performance of a particular set of assets. An index includes a group of securities of several publicly listed companies and factors in the prices of the securities, too.
It is used as an industry benchmark to understand the performance of a group of assets, stocks, mutual funds, or the stock market in general. In India, Sensex and Nifty are the two main market indices. They cover securities of a wide range of companies spread across different sectors. While market indices track a broad market, some are industry-specific.
Index – All You Need to Know
- An index is a statistical measurement unit used to monitor stock market change.
- Every index uses a different method to calculate the changes in the stock market. Hence, tracking the index more relevant to your invested companies would be best.
- People are now investing in index funds. These securities mirror a particular index and perform in line with that index.
- Indices play a significant role in the evaluation of your investment portfolio. Hence, you should keep track of the major indices.
Understanding indexes
An index provides real-time information on how the stock market is performing and the direction in which it is headed. When there is a rise in an equity index, it indicates that people are investing more in securities of the companies that are a part of the index. The opposite happens when people are selling more shares than buying them.
It acts as a benchmark to understand the performance of investments. It helps the investor understand if their investments outperform or are underperforming compared to the entire market.
Each index tracks the performance of a specific market or segment. Hence, you must select the correct benchmark for your portfolio. For instance, if you invest in mid-sized companies, keeping track of an index that measures small or large companies’ performance may not be helpful.
An index provider creates an index to track the performance of a market or a segment. It also helps you assess the asset class and define your investment strategy. An index is a performance indicator. However, there are several index-related securities available for investment.
Importance of a stock market index
The market index majorly represents market mood. The index reacts to electoral, political, and geopolitical events, mirroring the sentiment in the market. Besides this, the following explains the importance of an index.
Helpful in the stock selection for investment
With over 7,000 listed companies, it isn’t very easy to make stock picks to add to a portfolio without a comprehensive view of the performances of the sector and industry apart from individual stock.
The stock market index acts as a differentiator and groups stocks in an organised manner based on classification criteria. This criterion could be—market cap, sector, industry, company type, etc. For example, Nifty IT is a collection of the top 10 companies from the IT sector. Grouping similar stocks in an index makes it easier for investors to draw a comparison and measure performance against the markets.
Acts as representative
Major stock indices, Sensex and Nifty, are traditionally used by all investors to understand the market mood and sentiments as a whole. Similarly, a sectoral index movement reflects the direction of the particular sector.
For example, Nifty Pharma which represents the pharmaceutical sector, displayed a rising trend during the peak of COVID. However, the number of very large pharma companies (by market capitalisation) is fewer, and therefore, changes in Nifty Pharma have little impact on the Nifty 50 itself as the heavyweight Nifty IT or Nifty Bank. Hence, an index can be read separately or in relation to each other.
To understand the market mood, you can use Tickertape’s Market Mood Index (MMI). In case you want to dive deeply into it, read this – Market Mood Index (MMI): Time Your Investments Better.
Peer comparison
Indices serve as a dependable point of reference against which one can compare the performance of stocks before investing. This enables you to find out the performance of the stocks against the benchmark index, its performance in comparison to other companies in the sector, the performance of the entire sector, etc.
For example, suppose you wish to invest in the banking sector. In that case, you may assess Nifty Bank and find out which stocks have outperformed the benchmark index or have a greater stock valuation, which is doing better in terms of liquidity, etc.
Help passive investors
Picking the right stocks and keeping track of their performance requires time and a great deal of research. It doesn’t seem viable for passive investors who are looking to invest without constant monitoring. Hence, an index helps them understand the market or a market segment without putting too much time or effort.
Types of stock market indices
Talking about India, we have the following types of indices:
Benchmark indices: A benchmark Index is a group of securities used to measure the performance of other stocks or securities in the market. The Indian stock market is synonymous with the Nifty and Sensex. BSE Sensex, with 30 companies, and NSE Nifty, with 50 companies, are the two popular benchmark indices.
Sectoral indices: These indices account for different sectors of the Indian economy. The idea here is to group stocks belonging to the same sector under one index. Some examples are Nifty PSU bank, Nifty IT, Nifty Metal, BSE PSU bank, etc.
Market capitalisation-based index: This index category consists of companies meeting specific market capitalisation criteria. For example, NSE midcap 100 and S&P BSE midcap will consist of companies having a market cap exceeding Rs. 5,000 cr., but limited to Rs. 20,000 cr. Companies with a market cap of up to Rs. 5,000 cr will feature in BSE smallcap and NSE smallcap, while large-cap companies that command over Rs. 20,000 cr. will feature on indices like S&P BSE large-cap.
How does a market index select stocks?
If an index is a group of stocks, how does it arrive at a value? Let’s find out.
When an index goes up or down, it means that stocks under that index have performed better or worse. The movement of an index does not go up or down based on one stock. For instance, if Reliance Industries Ltd., which is listed on both, Nifty and Sensex, goes up by 5% during one trading session, the index will not reflect the 5% growth as the index has various other stocks as well, and they influence the movement of the stock as well.
Different stocks in an index carry different weightage. This weightage value helps in determining the value of an index. But how do indexes weigh stocks? Well, it depends on the stock selection criteria.
There are primarily two factors by which stocks are picked:
Market capitalisation
When the market cap is the base of the stock selection strategy, companies with similar market cap are grouped together in an index. Among those, companies with the largest market cap have a bigger weightage on the index’s value, while stocks with lesser market cap don’t influence the index as much.
In India, indices usually use a free-float market cap for assigning weights to their stocks. It is the company’s total value measured in the outstanding shares it has issued. To calculate free-float market capitalisation, use the following formula:
Free Float Market Capitalisation = Market Capitalisation x Free Float Factor
Where,
Market Capitalisation = the market value of the company
Market Capitalisation = Share price per share x number of shares issued by the company
Free Float Factor = percentage of total shares a company issues that are freely available to the public to trade. This can also mean the total outstanding shares of the company. It excludes all shares that the promoters, the government, group companies, etc., hold.
Price
Similar to the market capitalisation weightage method, some indices in the world use the price of a stock to give weightage in an index. Simply put, companies with a higher stock price have a higher weightage and impact than the lower-valued stocks in the index. For example, one of the global share market indices, Japan’s Nikkei 225, is price-based.
Index investing
Index investing has now become popular among investors. It is a passive form of investing or fund management, where a fund manager creates a portfolio of securities of the companies that are part of a particular index. In simple terms, the portfolio tries to mirror a specific index. Hence, the portfolio’s performance will directly depend on the index performance.
Index mutual funds and ETFs are two kinds of securities that are commonly used for index investing. Several futures contracts, life insurance, structured products, etc., use indices as an underlying asset.
Index investing securities must be liquid as they aim to replicate a particular index’s performance. Hence, you must be able to buy or sell the shares of an index fund as the index changes.
Index examples
Different kinds of indices help you understand a particular market or segment. Some of these include:
- Nifty 50
The Nifty 50 is an index managed by the National Stock Exchange (NSE). The index tracks the performance of the 50 largest blue-chip Indian companies. Hence, it is accepted as a representation of the Indian stock market.
- Sensex
Also known as S&P BSE (Bombay Stock Exchange) SENSEX, tracks the performance of the 30 companies that are a part of it. These 30 companies are spread across sectors and are some of the largest and most well-established companies. You can easily track the boom and busts of the Indian markets by tracking the S&P BSE SENSEX.
- Bank Nifty
The Bank Nifty Index comprises the 12 largest and most-capitalised banking companies listed on the National Stock Exchange (NSE). Hence, it acts as a representation of the performance of the Indian banking sector.
- S&P 500 index
The S&P 500 index measures the performance of the shares of the 500 leading US companies. Hence, it can be used to understand various investment products linked to these 500 companies. As the index covers almost 80% of the available market capitalisation, it is widely used to track the performance of the US stock market.
- Dow Jones index
This index measures the performance of blue-chip stocks. It includes 30 large public companies listed on the New York Stock Exchange and NASDAQ. This price-weighted index is impacted more by the changes in the highest-priced stocks.
- NASDAQ index
The NASDAQ Composite Index is a weighted index that comprises more than 3,700 stocks that are a part of the NASDAQ stock exchange. However, the index focuses on technology companies and is widely tracked worldwide.
- FTSE index
The Financial Times Stock Exchange 100 Index, also known as the FTSE 100 index, contains the 100 most highly capitalised blue-chip companies listed on the London Stock Exchange. The FTSE group manages this index.
Conclusion
An index overviews how a particular market or a market segment is performing. Hence, you get an overarching idea of the stock market performance. While some indices track 500 companies, others might track the top 50 or 30 companies. Use Tickertape to search and analyse all the indices in India, like IT, Pharma, FMCG, and more. Depending on your portfolio and investments, you can choose the ideal index to track. Additionally, you can use an index as a tool to facilitate passive investing.
