Discussions about the Indian stock market seem incomplete without using the words NIFTY and Sensex. What is NIFTY or Sensex? NIFTY or NIFTY 50 and Sensex are both the primary stock exchange indices of NSE and BSE respectively that determine the performance of the market. Let us try to understand the meaning of index, the composition of the index, the method of calculation of an index and its importance.
WHAT IS AN INDEX?
A stock market index is an indicator of the performance of the respective stock exchange in a standardized manner. Thousands of companies are listed on a stock exchange. For an investor, it is practically impossible to track the performance of each company. This results in the need for creation of a stock index. The index is an indicator of a few companies that perform better than the others. Market indices accumulate a particular group of companies and regularly computes them to show the performance of the overall market or a specific segment of the market.
COMPOSITION OF STOCK INDEX
The stock exchanges select similar stocks and group them together to form an index. The basis for the selection of stocks may be based on the industry to which the stock belongs, the size of the company, market capitalization, etc. The NIFTY 50 index comprises of 50 stocks. Similarly, the BSE – Sensex consists of 30 stocks. Some of the important indices in India are as follows:
The values of stocks included in an index directly impact the value of the index. Any change in the stock price (usually) affects the index value.
CALCULATING A STOCK INDEX
A stock index comprises of several stocks of a particular category. The method of selection of the stocks is prescribed by the index. Once the stocks are selected, the value of the index is calculated. The method of calculation may be a simple average or a weighted average of the prices of stocks selected. The weights used may be price, market capitalization, free float market capitalization, etc. The benchmark index of the National Stock Exchange i.e. NIFTY 50 is calculated based on free float market capitalization. Let us understand these terms before moving to the steps for calculation of the index.
Market Capitalization: It is the market value of all shares of a company. It is calculated as the market price per share multiplied by the number of shares issued by the company. Let’s say that the company ‘A’ has issued 1 Lakh shares and the price per share is Rs. 50 then the market capitalization of the company will be Rs. 50 Lakhs.
Free Float Market Capitalization: It is the market capitalization of the company minus the value of shares owned by the promoters of the company. If the promoters of the company ‘A’ hold 30,000 shares, the free float market capitalization will be Rs. 35 Lakhs (70,000 shares * Rs. 50).
Now that we have understood the concepts that determine the value of an index, let us check the method to calculate the index.
Note: An index, when calculated for the first time, is assumed to be 1000. This is the base index value. The level of NIFTY 50 index was assumed to be 1000 on 3rd November 1995 and has increased over time to around 11,500 at the end of the day on 18th September 2020.
Let’s check an example to understand deeply:
Assume an Index XYZ has 3 constituent companies Company X, Y and Z. The details of these companies as on Day 1, when the index is deemed to be 1000, are as follows:
The impact on the index on Day 2 based on the given price changes shall be as follows:
This value of the index keeps changing constantly as it is calculated on a continuous basis during the trading hours.
IMPORTANCE OF A STOCK INDEX
- Represent the market
Stock indices act as the representative of the performance of the market or the category of stocks that it comprises of. For instance, NIFTY 50 is a representative of the overall market whereas NIFTY Bank is a representative of the companies in the banking industry. Indices help to study the market without evaluation of each stock that is listed on the exchange.
- Grouping and Sorting
It is very difficult to pick the correct set of stocks for investment as the stock exchanges have thousands of companies listed. Stock indices offer you the best stocks in a particular category that is based on the size of the company, industry, etc. Let’s say that you want to assess the performance of the automobile industry. Instead of collating the data from all the listed stocks; the NIFTY Auto or the S&P BSE Auto index picks the top automobile companies to help you evaluate the entire sector.
- Comparison
Stock indices can be taken as industry benchmarks. Comparing the stock with its industry index helps the investors to gauge the performance of that particular stock vis-à-vis the industry index. Comparing the stock trends and the market trend will help you evaluate whether or not the stock has outperformed its benchmark (the index).
- Passive Investment
An investment in a portfolio of securities that closely resembles a particular index is called a passive investment. It helps the investors to save on costs related to research and stock selection. The portfolio will move in tandem with the stock index. Such investment will generate returns that resemble the change in the underlying stock index. Passive investment can be achieved through index-based mutual funds or an Exchange Traded Fund (ETF).
CONCLUSION
A stock index is an ocean of investment options. Choosing the right set of stocks may become difficult at the initial stages. This is where indices have a role to play. They help you filter stocks in a particular category, compare them with the industry benchmark and finally make informed investment decisions. However, one should always remember that investments are not free-size apparel and have to be altered based on the risk and return preferences of each investor.
Sources: Parts of this article have been taken from or have been inspired by related content uploaded on the website of NSE India, BSE India, Kotak Securities, Groww, Cleartax, etc.
Disclaimer: This content; including images and other visualizations, may include information from sources believed to be providing accurate information. Content and materials provided are for general information only. Views and opinions expressed in the article are personal opinions of the author and should not be considered as solicitation for investment in any security.
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