The two well-known stock market indices in India are Nifty and Sensex. They indicate the overall performance of the stock market.
What are Stock Indices?
Indexes are constructed based on a representative group of items from the entire universe and reflect the performance of the universe. Similarly, stock indices are indexes constituting the group of stocks listed on the respective stock exchanges that reflect the stock market’s or a particular category’s overall performance.
Nifty, for instance, reflects the performance of the stock market based on 50 constituents listed on the National Stock Exchange (NSE). Similarly, Sensex constitutes 30 stocks listed on the Bombay Stock Exchange (BSE).
Types of Stock Market Indices
Benchmarks refer to a standard reference point against which the performance of a similar thing can be measured, compared or judged. Similarly, benchmark indices mean key indices that reflect the stock market’s overall performance, with which one can compare his/her portfolio performance.
Nifty, an index constituting the top 50 stocks, and Sensex, an index constituting the top 30 stocks, are India’s benchmark indices.
Sectoral indices constitute stocks of top companies from particular sectors and reflect the performance of those concerned sectors. For instance, the Nifty Bank index demonstrates the performance of stocks of the top 12 banks in India listed on the NSE. Some sectoral indices are Nifty Auto, Nifty FMCG, S&P BSE Consumer Durables, S&P BSE Metals, etc.
A few sectoral indices, such as Nifty Bank, Nifty Financial Services, etc., also trade on the stock exchange.
Market-cap Based Indices
Market capitalization shows the market value of a company’s stock. All the stocks in the stock market are categorized as large-cap, mid-cap or small-cap based on market capitalization. There exist certain indices that include stocks based on their market capitalization. These indices help investors to evaluate the performance of stocks in large-cap, small-cap or mid-cap categories.
Some market capitalization-based indices are the Nifty Midcap 50, Nifty Smallcap 100, S&P BSE Smallcap, S&P BSE Midcap, etc.
Some indices, such as Nifty 100, Nifty Next 100, S&P BSE 500, etc., are broader stock market indices with more constituents.
How Does an Index Select Stocks?
All stock market indices have their own formula, theme or strategy for selecting stocks. Here are two popular methods by which stock market indices select stocks.
The market capitalization of a stock can be calculated by multiplying its current market price by its total number of outstanding shares. Popular indices like Nifty 50 or Sensex include stocks based on market capitalization. Hence, companies with higher market capitalization form part of and highly impact these indices.
In India, the constituents’ weights are decided based on free-float market capitalization. The free-float market capitalization is calculated by excluding privately owned shares, i.e., which are not publicly available for trading. Privately owned shares include shares owned by promoters, government, group companies, etc.
Some global indices, such as Dow Jones Industrial Average, Nikkei 225, etc., select and weigh the stocks based on their market price. It means stocks with the highest prices will form part of these indices, with higher weightage in the index than lower-priced stocks.
How Do Stock Indices Arrive at a Value?
Different stock indices might have different formulas to arrive at the value. Free-float market capitalization helps calculate Sensex and Nifty.
Firstly, the market capitalization of all 50 constituents is put together. From that, the free-float market capitalization of all of them is put together. The next step is to assign weights to stocks based on their free-float market capitalization, i.e. higher weightage to the one with a higher free-float market capitalization.
Then, the weighted free-float market capitalization is arrived at by multiplying weights with the free-float market capitalization of stocks. When the weighted free-float market capitalization is added together, it gives the current market value of Nifty 50.
Derive the value of Nifty 50 using the following formula.
Nifty 50 = (Current market value of Nifty / Base market capital) * Base index value
Base market capital = ₹2.06 trillion
Base index value = 1000
This involves calculating the market capitalization of all 30 constituents followed by the free-float market capitalization of all of them. Next step involves calculating the total free-float market capitalization by adding the free-float market capitalization of all 30 constituents. This value is put into the Sensex calculation formula.
Sensex = (Total free-float market capitalization / base market capitalization) * Base index value
Base market capitalization = ₹2,501.24 crore
Base index value = 100
Importance of a Stock Market Index
Groups stocks based on theme or strategy
All stock market indices have a group of stocks based on a particular theme or strategy. It makes it easier for investors looking to assess specific kinds of stocks or funds as they can find them in one place.
For instance, an investor wants to assess the performance of stocks in the FMCG industry. With many stocks listed in the FMCG industry, it may become difficult to evaluate them individually. However, sectoral indices such as Nifty FMCG or S&P FMCG that represent the performance of the group of FMCG companies can make the task easier and quicker for an investor.
Reflects overall market conditions
Stock market indices include top companies based on their theme or strategy. A rise or fall in the value of indices shows whether most of their constituents performed well or not. For instance, Nifty Smallcap 100 includes the top 100 companies that belong to the small-cap category by market cap, and an increase in its value may indicate that most small-cap stocks performed well and vice versa.
Similarly, benchmark indices, i.e. Nifty 50 and Sensex, reflect the overall market conditions. If such indices keep rising in value for a considerable time, it may suggest that the stock market is in a bullish phase and vice versa.
Aids in assessing individual stock performance
Investors can also use indexes to evaluate and compare the performance of individual stocks. For instance, how the stock performed compared to the index – if the Nifty rose, whether the stock rose or fell in value. If it rose, whether in a similar manner to index or better. One may also find how the stock performed compared to its peers in the index.
Stock market indices also provide information about price history, volume, volatility, sectoral performance, etc.
Reflects investor sentiment
Changes in the market value of stocks and indices result from demands and supplies, and increasing demand is reflected in rising prices. The increasing value of an index shows investors’ confidence in the stock market, and the falling value of market indices may indicate investors’ negative sentiments about the stock market.
Aids in passive investments
A passive investment strategy includes buying securities, such as index funds or exchange-traded funds, that track the performance of stock market indices. Thus, stock market indices act as underlying assets for passive investment returns.
Finally, stock market indices are so significant that it becomes difficult to assume the stock market without them. They make it easier for investors to make investment decisions by acting as a standard point of reference and comparison. The benchmark indices also reflect the investors’ confidence in the country’s economy.
Frequently Asked Questions
What are NSE and BSE?
National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) are two major stock exchanges in India that provide platforms for investors to trade stocks, bonds, derivatives, etc.
What are Nifty and Sensex?
Nifty and Sensex are benchmark indices of NSE and BSE, respectively, that reflect the overall stock market performance based on top companies according to market capitalization.
Are index and benchmark the same?
No, the index and benchmark are not the same. Indexes signify the performance of the stock market based on constituents, and a benchmark is a reference point against which the performance of something is compared. Different indexes act as benchmarks for various purposes.