All You Need to Know About Stock Market Indices

stock market indices

Markets Live: Sensex rises 350 points, Nifty tops 11,300

Ever wondered what statements like these meant? We keep hearing about Sensex and Nifty and others like S&P 500 and Dow Jones, but while some of us understand these, others find themselves clueless and often intimidated to even start investing. Well, we already know how crucial it is for us to start investing in the right places, so getting a hang of these topics is better for us. Whatever category you find yourselves in, we attempt to clarify everything about stock market indices for those who didn’t know and for those who do, you may end up learning something entirely unexpected.

 

Let’s get right down to basics

 

If you’re watching the markets regularly, that means you are tracking how indices are performing. A stock market index is nothing but a performance indicator of a selected group of stocks. If the stocks are doing good, so is the index and so is the overall market. In India, Sensex and Nifty are two of the most important stock market indices. Sensex covers stocks listed in BSE whereas Nifty is for stocks listed on the NSE. Before we proceed further, you should have an understanding of what stock market exchanges are and you can do so by checking out our earlier blog here.

There are many companies listed in both the exchanges and some of these companies’ stocks are then all gathered together, and are regularly measured to show how the markets are performing, which is what forms your index. Go back to your statistics class, and think of it as taking a sample out of a population of many. There are many ways in which a sample is taken, right? You can pick them out depending on sectors, you can pick out top performers among all, and you can further classify the next best and so on. And thus different indices are formed based on different classes of stocks. There are also a bunch of different criteria with which a stock gets included into an index – considering liquidity of the stock, minimum market-cap, minimum months of having been listed and others. 

So, having an index, gives you something to look up to, to compare different stocks, to see from an eagle’s point of view, how the market has been performing – whether it is healthy or whether investor sentiment is positive. 

 

What are the major indices?

 

It may strike your mind, that there are so many indices, are all of them really important? The simple answer is, that it depends on the purpose with which you want to track them. So, Let’s have a look at some of the major indices. 

Globally, there is among others, the MSCI World or the S&P Global 100 – measuring performance of stocks from all over the world. 

In the US, The Dow Jones Industrial Average (DJIA) is the oldest and most popular one and it measures the top 30 stocks listed on the New York Stock Exchange, the largest exchange in terms of market cap in the world.  The S&P 500 (Standard & Poor’s) covers 500 most popular stocks, almost 70% of the total market value. So you can realise from the numbers, that it represents a huge portion of the market. Then there is NASDAQ Composite, listed on the Nasdaq exchange (2nd in terms of market cap), which has the world’s foremost technology giants with it, be it Apple, Google, Microsoft or Amazon. Together, these three are the most followed indices when it comes to the US.

There are also others like Nikkei 225 of the Tokyo Stock Exchange (3rd), The Hang Seng index of the Hong Kong Stock Exchange (5th), where Alibaba is listed and FTSE (Financial Times Stock Exchange) 100 index of the London Stock Exchange (4th) – you get the picture.

When it comes to India, Sensex 30 and Nifty 50 are the benchmarks of all the indices. The S&P Bombay Stock Exchange Sensex (combining the words ‘sensitive’ and ‘index’) collects the 30 best performing stocks on the BSE. When best-performing comes to mind, you think of companies like Reliance, ITC, Nestle India, HUL, Tata etc, which are responsible for much of India’s industrial growth. Nifty 50, similarly, measures 50 stocks listed on the NSE, having some of the same names as above. These are the market benchmarks, and rightly so, because they are the most concise and act as the best references for the market. 

We have discussed the above indices based on top stocks in terms of market capitalisation of a company. How is that calculated? Well, you take the price of one share of the company and simply multiply it with the total number of shares of the company. So if the demand for the stock is high, people think it is a good investment, the price is high and so is the market-cap. But suppose you don’t want the top, you want to know how the pharma sector is doing. Then you can check out NSE Pharma and S&P BSE Healthcare as your indicators. Similarly, there exists indices for gold, public sector banks, indices which measure the lower market-cap companies like NSE midcap 100, BSE midcap etc. 

 

That is all okay, but how do you arrive at an index value?

 

We will just briefly dip into the calculation part of it. This inside information can be very useful in trading. Broadly, we can say there is a direct method and an indirect method. 

You can directly just add the prices of all stocks in a group and there you go, you have the price of the index. Or, indirectly you can assign certain weights to them, which makes more sense, as higher the weightage, higher its influence. Assigning weights is most popularly done through two ways, either it is based on free-float market-cap basis – which most of the indices follow, or the less popular price weightage system. 

Let’s take an example to clear this out. If there are 2 stocks, A and B listed on a particular exchange. A has 100 shares in total, but 30 of them are ‘free-floating’, meaning they are available to trade in the open market, and are not held by promoters or locked-in. The price of each share is, let’s say Rs 5. Then market-cap is Rs 150 (30×5). 

B has 200 shares, 50 of them are free-floating with a price of Rs 10 each. Then market-cap is Rs 500. 

Sum them up and you have an index with a free-float market cap of Rs 650. We take this value, and we take the value of the same index in a particular year, the base year, let’s say it was Rs 500. Divide the current market-cap with base year’s market-cap  and multiply by 100(the base year’s value)  → you have the current index’s value which is 130. This is the market-cap weighting method and if you were to assign weights based on price, then it would be a price-weighting method. Indices like Dow Jones and Nikkei 225 use the latter. Don’t worry if the calculation stumps you, it’s just important that you know the basic concept of it.

Here, we have taken a base value of 100, which is the same as Sensex’s base value and for Nifty, it is 1000. It’s easy to see here that, B’s market cap being more than A, it has more of an influence in determining the value of the index. Flipside is, if the higher weightage ones perform badly one day, it could throw off the index too. 

 

What does it all say about investing?

 

Think firstly, of an index’s importance. Had there not been an index, would you have known exactly how the market is doing? Would you have known which stock is doing better or worse if you didn’t have something to compare it with?

You can choose to buy some of the stocks on the index. If it is sector-specific, then you also get a bunch of stocks of that particular sector’s index, and that will lead you to build up a diversified portfolio. Had there not been an index to track the performance, you would have had to do the hard work yourself, hunt and research about every single one of them. If you also want to invest in certain commodities like oil or gold, simply buying them and storing them is not a good idea. You can, although, just look at a certain index and buy commodities listed there. 

Indices also move up or down, which says a lot about markets. If it is going up, we say the market is ‘bullish’, reverse it, and the market is ‘bearish’. A bullish market is one where stock prices are rising, investors have a positive outlook. A bearish market means the stock prices are receding and there is trouble in the economy. With the coronavirus pandemic, we have seen pretty bearish trends in the economy. 

So when we said that Sensex moved by this many points and then Nifty topped to approx. 11,000, it basically meant that there has been an increase in the price of certain stocks listed in the exchanges, which has led to an increase in the overall index value over the previous day’s. It may also mislead you in certain cases, that suppose an index rose by 100 points and other only by 50. You will say that the first one fared better. But you need to look at what the starting value was for the index. If it rose by 100 from a value of 5000(2%) but the other one rose by 50 points, true, but from a value of 500(10%). In percentage terms, the second one grew more. So focusing on percentage changes is better.

When stock prices rise, the investors benefit, their wealth rises which leads to more consumer spending and is overall beneficial for the economy. You may not have a risk-appetite that is suitable for investing in all the stocks in a particular index. You may find some others that are not part of an index but you can see that their value might be better than an index. This is also where the concept of index funds come into play. Index funds have a collection of stocks that closely matches a particular index and tries to closely resemble its returns – a form of passive management while if a fund is managed actively, then they try to outperform the market index.

 

Thus, gaining this knowledge is beneficial for any investor, whatever be your purpose of investing in the stock market. Having these benchmarks, can really help in terms of identifying how the overall market is, and give an investor a very deep insight into how the overall market sentiment is. You save a lot of time and energy by simply looking at these values which can eventually, help you take stock of what is going on, identify what is wrong and if you have the right attitude and the patience to regularly watch the markets, it can even make you an expert on stock markets, in which case, you won’t be needing us anymore. 

 


 

One Response

  1. Aman Dalal says:

    Thanks for the article
    Now I got better understanding of stock market

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