What are stock indices and their importance?

Sensex and Nifty are possibly one of those terms in the stock market jargon which almost everyone must have come across multiple times, be it through newspapers, news apps or our relatives discussing the stock market. Sensex and Nifty are few of the many stock indices in our country and the concept of stock indices is central in understanding the Indian Stock market. In this article, we will find out what are stock indices and their importance.

What is stock index?

Let’s begin by understanding what is meant by the term stock index or indices.

A stock index is essentially a statistical measure that portrays any changes in the trends of the stock market in general. An index is created by grouping stocks together based on a defined criteria depending on the characteristics of a particular index.  Stocks in an index are selected using some criteria, which may be market capitalization, type of industry, theme or some investment strategy.

The value of the index is calculated using the values of the underlying stocks in the index, and consequently any changes in the prices of these stocks impact the overall value of the index. So, if majority of the stocks in the index were to witness an increase in their prices, the value of the index will go up as a whole and vice-versa.

Let’s now look at a few examples of stock indices in India.

Stock indices can either be broad market indices like S&P BSE Sensex and NSE Nifty, Sectoral indices like Nifty FMCG and S&P BSE Healthcare which are a gauge of companies falling under a particular sector, and indices based on market capitalization like S&P BSE Small cap and S&P BSE Midcap.

Let’s now take a detailed look at the 2 broad market indices in India, the BSE Sensex and the NSE Nifty.

Sensex is India’s oldest stock index, introduced in the year 1986. It consists of the 30 stocks of largest, liquid and financially sound companies of the key economic sectors listed on the Bombay Stock Exchange, BSE. NSE Nifty, also known as Nifty 50 was created in 1996 and consists of the 50 largest and most liquid stocks from major economic sectors listed on the National Stock Exchange, NSE. 

How indices arrive at a value?

One should know that each stock has a different price and a change in one would not be in proportion to the other in an index, and leadingly, the value of an index cannot be determined by simply summing up the prices changes of all the stocks which fall under the index. And that is why every stock is assigned a particular weight in proportion to its market capitalization. This weight can be roughly considered to be a representation of the impact which any change in the price of the stock will have on the value of the index.

Indian indices make use of the free-float market capitalization to assign weights to a particular stock falling under an index. Market capitalization measures the total value of the company as a product of the company’s stock price and the number of its shares outstanding in the market. Free float market capitalization excludes the shares held by promoters and only incudes those shares which are freely available in the market for trading.

Why we need indices?

A stock index essentially acts like a barometer reflecting the overall condition of the markets or the sector it represents. Indices are incredibly useful for assessing the general direction in which the market seems to be heading.

Indices assist investors in selecting appropriate stocks for investment and act as a reference point to measure their performance. One can assess performance of stock portfolio, whether the portfolio outperforms the index by giving higher returns than the index or does it underperform by delivering lower returns as compared to the index. Since an index usually consists of companies grouped together according to some aspect, it acts as a parameter of peer comparison. As an example, one can understand which bank amongst those listed in the index Nifty PSU bank has delivered the highest returns in the past year.

One of the most crucial benefits of indices is their ability to reflect investor sentiment. It is a well-known fact that investor sentiment is an important factor in driving the price of a stock as it directly impacts the demand of a stock.

Indices are also a helpful tool for passive investors who wish to reduce the cost and time required to carry out research in selecting the most appropriate stocks according to their risk appetites and goals. Hence, they construct a portfolio consisting of the stocks tracking a particular index to replicate the returns delivered by that index or invest in index ETFs (Exchange traded Funds).

Also Read: Understanding Commodity Indices

Conclusion

All in all, indices are extremely important as a representative or a benchmark of a particular sector or the entire market as a whole, and it serves as a very handy tool for investors to assess a multitude of aspects, from the performance of their portfolio to the impact a particular event has had on the market performance.

After reading to all of this, one should be able to understand what people mean when they say Sensex has gone down by 350 points or that Nifty has gone up by 200 points and what exactly is meant by such fluctuations in the markets.

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