What are stock market indices and their significance?

Stock Market Overview

There are thousands of companies listed on stock markets, making it almost impossible to monitor every company. That’s why stock market indices are created just to ease the difficulty of every trader and investor. Basically, a stock market index is a collection of stocks that fall under a particular category or have similar characteristics.

Market indices generally combine a select group of company stocks and regularly measure them to show the overall market’s performance or a certain segment of the market. To be more precise, an index assists the investors in understanding the sentiment of the market as well as makes it easy to compare the performance of an individual stock.

You will get many different types of stock indices available in the market, such as sectoral indices representing the stocks of particular sectors, volatility indices representing the relative volatility in the market, etc. Anyway, the Sensex and Nifty-50 are two popular benchmark indices that mainly deliver the performance of the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). Do not get worried. We have covered all the essential information related to the stock market indices to clear your concept. Let’s dig deeper into the article.

Explanation of Stock Indices

Stock Indices

An index is formed by selecting and grouping a number of similar stocks from the listed company stocks on the exchange. The classification is done on the basis of the industry the companies belong to, the size of the companies, their market capitalization, and other bases. Let me give you an example to make you understand better. If we talk about the BSE Sensex and BSE 500, then these two will stand for indices containing 30 stocks and 500 stocks in the Bombay Stock Exchange, respectively.

The values of the grouped stocks are used to calculate the value of the index. Besides, any change in the price of the stocks leads to a change in the index value. Hence, an index is an indication of the changes in the market. I have listed here some of the crucial Indian stock market indices.

Standard Indices – Sensex (BSE) and Nifty (NSE).
Sectoral Indices – Nifty Auto Index, BSE Bankex, etc.
Market Capitalization Indices – BSE Smallcap, BSE Midcap, etc.
Broad-Market Indices – BSE 100, BSE 500, etc.

Significance of Stock Indices

Indices are considered an essential part of the stock market, and that’s why it is very important to learn about their significance. In our article, we have provided you with an in-depth analysis of their needs.

Sorting of Indices – Firstly, there are various companies listed on the stock exchanges. Now, people are compelled to think about how to differentiate among those and pick the preferred one or two to buy. In general, ordinary people do not know on what basis these are sorted. Well, it is where the indices come into the picture. The classification of indices is done based on critical characteristics like the industry or sector these companies belong to, the size of the companies, and other factors.

Representation – An index acts as a representative of the whole stock market or a particular segment of it. The BSE Sensex and the NSE Nifty are treated as the standard indices in the Indian share market. These two indexes provide the entire market’s performance on a broad category basis. At the same time, an index formed of Nifty Auto describes all stocks of the automobile industries.

Comparison – An index makes it easy for an investor to compare the performances of different stocks. Further, they can even compare a company’s stock price with the standard indexes such as the NSE Nifty and BSE Sensex to understand the market’s performance. If you want to check whether a particular stock has outperformed the market or not, you can just compare the price trends of the index and that stock. Simultaneously, the traders can even compare a group of stock prices with a standard index or simply another stock index. Just imagine that the Nifty 50 has increased by 275 points. In spite of this increment in the Nifty 50 index, a specific segment of stocks like automobiles is not advanced. Then you can pretty easily understand that the stock prices of the automobiles sector have not been enhanced by comparing it with the benchmark index. As a result, the investors identify the market trends effortlessly.

Reflection – Among a set of important psychological aspects, the sentiment of investors matters. If they have a positive mindset or sentiment, there will be a demand for a stock, resulting in the rise of the stock prices. The indices express the mood of the investors. Summing up, an index helps compare it with a standard index to check whether it has boosted or decreased performance. All in all, it will reflect the sentiment of the investors or traders.

Passive Investment – Several investors invest in a portfolio of securities or stocks that nearly matches an index, called a passive investment. In addition, an index portfolio assists investors in cutting down the cost of research and stock selection. These investors simply depend on the indexes to choose the stock they want to invest in.

Formation of Stock Indices

Every stock has a different price. In general, if there is a 1% change in one stock, it does not mean that another stock will have the exact change in its prices. Plus, it suggests that the index value can not be the total price of all the stocks. Instead, the index is calculated depending upon the price or market capitalization of the selected stocks.

Usually, stock market indices are weighted according to three categories.

  • Market-Capitalization Weightage – Market capitalization is calculated by multiplying the current share price of a stock with the total number of stocks floated by a particular company. Therefore, both the size and price of the stock are counted in this method. For example, if a company has a market cap of INR 20,000 and the index it belongs to has a market cap of INR 2,00,000, then the weightage of this company will be 10%.
  • Price Weightage – In this method, the index value is calculated based on the highest stock price of a company and not on the market capitalization. If a company’s stock “A” has a higher rate than a “B” company’s stock, then “A” will be provided more weightage than “B” in the index they both belong to.
  • Equal Weightage – In this process, each stock has equal weightage irrespective of share price and market capitalization.

Bottom Line

I hope the article is helpful enough to give you a brief idea about the stock market indices, their significance, types, and formation. In India, most indices use free-float market capitalization. In free-float marketing, only the total number of shares publicly available for trading is used instead of the total shares listed by a company to calculate the market cap. It makes the free-float market cap a smaller figure than the market cap. On the other hand, the rest of the weightages are not used in India on a frequent basis.

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