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When we hear that someone got failed an exam, we immediately got the idea that he would get less than 33% out of the total marks. How? Because we know that, 33% is the benchmark which one has to cross to pass the exam and thus how we get to know the performance of any student.
But what when an investor wants to know the performance of the stock in which he/she invested.
And here, not just as a performance benchmark, the Stock market index comes into the picture.
What are Stock Market Indices?
There are so many companies that are listed on the stock exchanges, out of those hundreds and thousands of companies the regulator grouped (the criteria based on which the grouping is done is described later in the article) specific no. of stocks of those companies and form an indicator which could tell us how the whole stock market is performing at a given time.
This indicator is known as the Index/ Stock index/ Stock market index.
What is the need for an Index?
We need a stock index because it is impossible to track every stock to analyze the stock market that’s why we take a specific quantity of stocks as a sample and evaluate the market’s performance by tracking that sample.
Types of Stock indices
Generally, what most people know about the name of the indices are Sensex and Nifty but there are also other indices out there of which they’re completely unaware.
1. Benchmark indices
Indices that investors use to measure the performance of the other stocks, bonds, mutual funds and the securities of the stock market.
2. Sectoral/Thematic indices
Indices that represent the particular sectors like pharma, banking, telecom etc.
Some examples are:
- BSE Bankex
- Bank Nifty
- Nifty FMCG
3. Market capitalization-based indices
These are the indices that are formed based on market capitalization.
- BSE Largecap
- BSE Midcap
- BSE Smallcap
4. Broad market indices
Indices that are broad-market indices consist of the large, liquid stocks listed on the exchange. They serve as a benchmark for measuring the performance of the stocks or portfolios such as mutual fund investments.
Some examples are:
- Nifty 100 Index
- Nifty 200 Index
- Nifty 500 Index
Importance of indices
From the start, you’ve read that people use the index as a performance benchmark but it isn’t the only reason why we have the index or why we need one in our stock market journey.
There are plenty of other reasons which are…
1. Economic indicator
There are so many indicators by which you can analyze the economy of a country like GDP, Interest rates, Unemployment, stock market etc.
Not from the perspective of an investor but another perspective let’s say, as an analyst, what do you think whether one will chase each stock of the listed companies on the stock exchange to get the track record of the stock market?
And that’s why to get an indication of the economy, we also use indices.
2. Represent sentiments of the investors
We’ve discussed the definition of the index. It is the grouping of the stocks of some listed companies.
If we’re considering stocks then surely there would be the share price and the price of a share depends on the demand and supply in the market.
If the demand is high and the supply is low, we say the people are greedy now.
If the demand is low and supply is high, we say the people are in fear that’s why they’re selling.
And this is how we get the mood of the investors by just keeping an eye over the index/indices.
3. Investment option
Did you hear about the index fund?
Yes, indices are also a source of investment.
If you say, I want to invest in Sensex and/or in nifty by myself i.e. you want to invest directly into the index which isn’t possible because there isn’t any such facility.
But you can invest indirectly through mutual funds where you get the exact (obviously, there is a fee which the mutual fund charges) percentage of the return by which the index moves.
You can directly invest in index as a product via the derivative market.
How indices were created
Every index in the stock market world could be categorized into two categories, either they’re based on market cap weightage or price weightage.
- Price weightage:
The companies with high share prices. are chosen and grouped to form an index. Stocks with higher prices have greater weightage in the index than stocks with lower share prices.
e.g. Japan’s Nikkei 225 and US’s Dow Jones Industrial Average (DJIA).
- Market capitalisation weightage:
Here, we select the stock of the companies which have the highest/largest market cap in their respective sectors and, as obvious, give weightage to the stocks which have a high market cap.
e.g. Sensex and Nifty.
In India, we’ve indices that have market cap weightage. So, now we’re gonna discuss how Sensex and nifty were created.
Understand the following terms: 1. Base year: Year in which the index was created. 2. Base value: It needs to be decide first. For instance base value for sensex is 100 and for nifty it is 1000. 3. Base market captitalisation: The aggregate market capitalisation of each stock in the index during the base year.
Here, we will create our index but this index will have all the characteristics that Sensex and nifty have. for example, Sensex and nifty comprise 30 and 50 stocks respectively but here we will take 5 stocks to make it simple to understand.
The Sensex and nifty were created in the same way with a twist of information like:
- Base year – 1978-79
- Base value – 100
- No. of stocks – 30
- Base year – 1995-96
- Base value – 1000
- No. of stocks – 50
How indices are calculated
Stock market indices are the most important element of the stock market world. A lot of terminologies that the investors use include the term stock index.
“market got corrected by x%”
“beating the market”
“this stock outperformed/underperformed the market”
You can see the word “market” is repeated in all the above examples and here the word “market” is used for nothing other than the “stock index”.
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