Beginner’s Guide to Stock Market Indices
We often read online or in newspaper or hear people saying that the ‘market’ jumped or that the ‘market’ fell. However, on reading the stock table, you will see that not all stocks rose or fell. There were some which moved in the opposite direction. Then what does that ‘market’ mean? It means an index. Continue reading to know more.
What are stock market indices?
From the stocks listed on the exchange, some same stocks are selected and grouped together to form an index. This classification may be on the basis of the size of the company, the industry the company belongs to, market capitalization etc. E.g. the BSE Sensex is an index that includes 30 stocks;likewise, the BSE 500 is an index that consists of 500 stocks.
The value of the index is calculated using the values of the grouped stocks. Change in the price of the stocks also changes the index value. An index is therefore indicates the changes in the market.
Some of the important indices in India are:
- Benchmark indices – BSE Sensex and NSE Nifty
- Sectoral indices like BSE Bankex and CNX IT
- Market capitalization-based indices like the BSE Smallcap and BSE Midcap
- Broad-market indices like BSE 100 and BSE 500
How are stock indices formed?
An index comprises of similar stocks. This could be on the basis of market capitalization, company size, industry or another parameter. After selecting the stocks, the index value is calculated. This could be an average of the prices of the components. In India, the free-float market capitalization is popularly used rather than prices to calculate the value of an index.
Why do we need indices?
Indices are an essential part of the stock market. Here’s why we need stock indices.
- Sorting
Thousands of companies are listed in a share market. How do you differentiate between all of those and choose one or two to buy? How you can sort them? This is exactly where indices prove helpful. Companies and their shares are classified into indices depending on industry or sector they belong to, the size of company etc.
- Representation
Indices work as a representative of the complete market or a particular segment of the market. In India, the BSE Sensex and the NSE Nifty are considered the benchmark indices. They are known to show the overall market performance. Similarly, an index formed of IT stocks is supposed to signify all stocks of companies from the industry.
- Comparison
An index makes it simpler for an investor to compare performance. It can be used as a benchmark to compare against.E.g. in India the Sensex is usually used as a benchmark. So, in order to know if a stock has outperformed the market, you just compare the price trends of the index and the stock. Also, index can be used to compare a set of stocks against a benchmark or another index. This helps investors in identifying market trends easily.
- Reflection
Investor sentiment is a very crucial factor of stock market movements. This is because, if sentiments are positive, there will be demand for a stock. This will lead to increase in prices. It is very tough to gauge investor sentiment in a right way. Indices assist reflect investor’s mood- not only for the overall market, but even sector-wise and across company sizes. You just have to compare an index with a benchmark to find out if it has outperformed or underperformed.
- Passive Investment
Many investors prefer investing in a portfolio of securities that highly resembles an index. This is termed as passive investment. An index portfolio assists investors cut down price of research and stock selection. On the basis of index they choose stocks. As a result, portfolio returns will match that of the index.
We hope you found this article helpful and will be now able to compare the stocks on the basis of stock indices and make more profits.