There are several companies listed on stock exchanges. So how do we measure how these stocks are performing? By studying the performance of each company? That can be a humongous and tedious task. So we have stock market indices. So, what is a stock index?
An index in general measures or quantifies change. But what is index in stock markets? It is a guide to how particular stocks, (that represent the market), are performing. It is a measure of change in the performance of these stocks. Indian stock markets, for example, boast of indices like the benchmark indices-NSE Nifty and BSE Sensex, BSE Smallcap, BSE Midcap or BSE 100. But how are these indices created?
What is a stock index but regrouping of select bellwether stocks? A group of stocks are put together from those listed on an exchange based on some criterion. The shares could be chosen based on the size of the companies (market capitalisation), sectors, or industry. Some indices also specifically track value stocks or growth stocks.
The stock index derives its value from the value of the underlying securities. This is how the performance of a stock index primarily reflects the performance of the underlying stocks. For example, if most of the shares in the index are showing gains, you will see the stock index rise too, and if investors sell these underlying shares, the index will show losses also.
The purpose of a stock market index
A stock market index has an indicative role to play. It reflects the overall health of the stock market and which direction the market is headed. An index is also an indicator of market sentiment. If an index is consistently performing well, that would mean the underlying companies are performing well too, and that signals a bull market (a positive market sentiment). If the indices are underperforming, that would mean the underlying stocks are also failing. That might be a sign we are in a bear market (negative market sentiment).
Why should you monitor a stock market index?
- It is an easier way to pick stocks
Since shares are bunched together, it becomes easier to monitor them.
- It represents the stock market
Stock indices represent the performance of the stock market in a way. For example, in India, we have the BSE Sensex and NSE Nifty which are benchmark indices. They are the benchmark for analysing the performance of the stock markets. The returns on index mutual funds are also benchmarked to these indices.
- To compare performance
As an investor you must know how stocks perform. A particular stock is said to outperform an index when the returns on a stock are higher than yields on the index. This helps you plan your stock investments better. So you are not saddled with poorly performing stocks.
- To help investors replicate the performance
Some investors use the replication strategy for investing in stocks. It is called passive investment. What they do is they invest in a portfolio of stocks similar to ones on a well-performing index. So the returns on such a portfolio will resemble the returns on the index. Passively managed funds fall in this category. These funds are benchmarked to stock market indices and look to replicate their returns.
Development of a stock index
A stock market index, as we said earlier, consists of several stocks selected based on particular criteria. It is interesting to see how one arrives at the value of an index. This value is not cumulative of all stock prices; instead, shares are assigned weights within the index. Stock indices could be price-weighted or market-cap-weighted. Based on how much weight each share gets allocated, it determines how much movement in the cost of the individual stock will impact the performance of the overall index.
A market-cap-weighted index would assign weights based on the size of the companies in it, irrespective of their price. Market capitalisation is the total market value of the company stock. So the weights are assigned based on the market size of the company in comparison to the market cap of the index.
Example- Company A has a market cap of 70, and the total market cap of the index is 100, then Company A will have a weight o 70% in the index.
There is the free-float market capitalisation method that computes the market value of the stock based on the shares of a company that are being publicly traded, for indexing. They exclude, for example, shares held by the promoters. This reduces the weight assigned to the company in the index accordingly. In the above case, if the free-float market cap of company A is 50, then company A will have a weight of 50% in the index.
Price weighted indices, for example, assigns weights based on the stock price, irrespective of their market cap. So a higher-priced stock, even if smaller in size, will have higher weight in a price-weighted index.
Indian Stock Market Indices
- Examples of market cap based indices include BSE Smallcap, NSE Midcap,
- Examples of sector-based indices include NIFTY Auto Index, NIFTY Metal Index, NIFTY Pharma Index, among others.
- Examples of broad market indices include BSE 500, NIFTY Smallcap 250, NIFTY 500, NIFTY 50, among others.
- Free float market cap based indices include BSE Sensex.
- Some of the global stock market indices include the MSCI World Index (it tracks marge and mid-cap stocks from 23 developed countries and 85% of the free float market cap from these countries), FTSE All-World Index, S&P Global 100 Index, Dow Jones Industrial Average.
What is NIFTY 50?
NIFTY 50, for example, is a diversified index of 50 stocks covering 13 sectors. Owned by NSE Indices, the 50 stocks on NIFTY 50 represent about 66.8% of the entire free-float market capitalisation of stocks listed on the exchange. In other words, if the total free-float market capitalisation of all the stocks listed on NSE were 100, the free-float market-cap of the shares included in NIFTY 50 would make up 66.8% of it.
What is BSE Sensex?
S&P BSE Sensex is one of the most widely followed stock indices since its inception in 1986. It tracks the performance of country’s top 30 most liquid and financially stable companies listed on the Bombay Stock Exchange. These companies are from across significant sectors.
For those looking to invest in stocks, an excellent place to start is by tracking the performance of some of the leading stock market indices. These indices help you see where the market sentiment is headed, what sectors are performing well and the winning horses.