We normally hear colleagues and friends say that a stock market is up or down an X number of points today. Or that currently, the stock market is in a bullish or bearish phase. So how exactly do people make these calls? What is the reference point or data that they are referring to?
The reference point is nothing but the Stock Market Index. Sometimes also known as the barometer of the health of an economy of a particular market or country.
Let’s take a deeper dive and understand all there is to know about Indices.
There are two major stock exchanges in India. The National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). Investors can trade or invest in stocks through the platform provided by these exchanges.
Of the thousands of stocks available on these exchanges, certain numbers of stocks are chosen to represent or benchmark the performance of the overall market.
The primary index of the NSE is called the Nifty and is made up of 50 stocks while the primary index of the BSE is the Sensex and comprises of 30 stocks.
These stocks which make up the index measure or represent the broad trend in the market or a certain sector. The Nifty and Sensex are also used to represent the Indian stock market globally.
So, when someone says that the market is up or down what they are referring to are the Indices.
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There are more than 5000 stocks listed on the stock exchanges, how does one differentiate between and choose the right one for investment. An index classifies stocks based on important parameters like liquidity, size, industry, or sector among other factors. This helps in identifying the best of stocks in one place.
Once an investment has been made the next step is to compare the performance of that stock. An index can tell you if your stock is performing better than the broader market or not. If it is a riskier investment compared to other stock and in turn fine tune your investment strategy.
It can also help in understanding historical returns vis a vis other asset classes like debt and gold.
Since the Indices are a collection of the best stocks listed on that stock exchange, they are a fair indication of the prevailing sentiment in the markets. Tracking investor sentiment is an important part of investing. Positive market sentiment will see stock prices moving up and vice versa in the case of negative sentiments. Stock market indices reflect the broad market mood.
Across the world, passive investing is gaining acceptance. As an investor, you can choose to eliminate the risk of choosing a particular stock and invest in instruments that largely mirror the performance of the broader market or index. This can be done through investing in an Index fund or Exchange Traded Fund (ETF).
There are various methods used to construct indices. Three of the most commonly used are
Market Cap Weighted – where companies with the highest market capitalization are given a higher weightage.
Equal Weighted – here all stocks are given equal weightage irrespective of the size of the company.
Price Weighted – where a company is assigned a weightage based on the current share price and not on how big or small the company is.
In India, we mostly use the market cap weighted method of including stocks in the Indices. Based on the market cap companies are grouped to constitute an index. The companies with a bigger market cap are assigned a higher weightage and as such can influence the movement of the Index to a larger extent.
Further Indian indices used the Free Float Market cap method of inclusion.
The difference between Market Cap and Free Float is that the latter is calculated excluding promoter holding and considers the total number of shares available for trading.
These are a collection of the most liquid and largest financially sound companies in the stock market.
Examples: Nifty made up 50 stocks listed on the NSE & Sensex made up of 100 stocks listed on the BSE.
Some others in this category include NSE Mid Cap, BSE Mid Cap, BSE Small Cap.
These are indices specific to a particular sector and capture the sentiment in that particular sector.
Examples: Nifty Bank, Nifty FMCG, BSE IT, BSE PSU
Created on specific investment themes such as manufacturing, consumption and commodities among others.
Examples: Nifty Commodities, Nifty Infrastructure, Nifty 50 Shariah, BSE Bharat 22 Index
These indices are designed based on a quantitative model or investment strategy to provide a single value to the performance of the underlying companies.
Examples: Nifty Alpha 50, Nifty High Beta 50, BSE Enhanced Value Index, BSE Low Volatility Index.
One can invest in a particular index like the Nifty or Sensex via Index Funds that mirror that particular index.
If you are a new investor, index funds are a good way to start. They tend to have lower volatility compared to individual stocks and to an extent mutual funds. But the compromise can be on the returns front.
However, if one is risk averse and wants predictable returns over a longer investment horizon, index funds are a viable option.
Indices are an important barometer of the state of the markets or economy of a country.
Indices help in evaluating and benchmarking investments across various asset classes.
Passive investment is possible through Index Funds based on the underlying Indices.