Personal Finance

A Quick Guide To Stock Market Indices

January 18, 2021

A Quick Guide To Stock Market Indices

If you want to monitor a stock out of the several listed companies, it would become a chore. Instead, having a ready reckoner gets the work done in a jiffy. This is why stock market indices are extremely important. They combine a set of relevant stocks and measure their performance to reflect the overall health of the stock market. Let’s get a deeper understanding of these.

What are Stock Market Indices?

A stock market index represents a group of similar stocks that are classified on the basis of certain key characteristics like industry type, company’s size, & market capitalisation, among others. They tell you about the quantum of performance and direction in which the underlying stocks are moving. This way you may decide how to go about your overall asset allocation in your portfolio for equities.

In India, the Sensex and Nifty-50 are regarded to be the popular benchmark indices that indicate the performance of Bombay Stock Exchange (BSE) and National Stock Exchange (NSE) respectively. Additionally, there are sectoral indices that help you to understand the behaviour and performance of specific sectors of the stock market. Some of the well-known sectoral indices are Nifty Auto Index, Nifty Bank Index and the likes.

How are stock market indices created?

Initially, the stocks are grouped based on factors like type of industry or size of the company. After this selection, each stock’s market capitalization (m-cap) needs to be calculated wherein the stock price is multiplied by the total number of stocks that are publicly available for trading. Then the weightage is assigned to each stock on the basis of their (m-cap).

Imagine Stock X has a market capitalization of Rs. 20,000 and the index, of which it is a part, has a total m-cap of Rs. 1,00,000. Then, Stock X’s weightage would be 20%. Likewise, another stock that has a market-cap of Rs. 50,000 would be given a weightage of 50%. Post that, the free-float market capitalisation of all the stocks is summed up to arrive at the total index m-cap. Finally, the Value of Index is computed using the following formula:

Index Value = (Total m-cap/Base m-cap value) * Base Index Value

It means that any change in the price of the underlying stocks would cause a change in value of the index. In this way, an index acts like a representative of the entire market/segment.

Why do we need Stock Market Indices?

There are a host of benefits that you get from stock market indices:

Identifies Market Trends

An index represents all the underlying stocks that it tracks, it acts like a barometer of the market. It provides you a quick outlook of industry/sector performance without you having to look at prices of every listed stock. This allows you to judge the state of a particular segment/whole industry and invest accordingly.

Acts like a Benchmark

With an index, you can easily ascertain if your portfolio has delivered returns as expected. When you compare a stock’s/portfolio’s return with that of an index, you can determine whether the stock/portfolio has performed better (outperformed) or worse (underperformed) than the market. Likewise, you can compare sectoral indices with each other to spot potential for higher returns.

Reflects Market Sentiment

A look at an index would reveal investors’ attitude towards growth prospects of a stock/sector. Generally, when a stock is in high demand, its price rises that causes the overall index to rise. Similarly, stocks that are less popular exhibit a fall in the price that in turn pulls the index values downward. In this way, a rising index indicates positive sentiment whereas a falling index indicates otherwise.

Supports Passive Investment

When you want a passive investment option without having to go through an extensive research, index may come handy. These offer you a low-cost stock portfolio that you can replicate for yourself to earn returns that resemble the underlying index. If you happen to be a first-time investor, indices can help you to kick-start your equity investment.

Which are the important Stock Market Indices in India?

Given below are a few popular Indian indices:

Benchmark indices – BSE Sensex and NSE Nifty
Sectoral indices – BSE Bankex and CNX IT
Market capitalization-based indices – BSE Smallcap and BSE Midcap
Broad-market indices – BSE 100 and BSE 500

Conclusion

Indices can give you a general idea about the market pulse. However, to succeed, you also need to consider other factors like your financial goals, risk profile and investment horizon. At Paytm Money Stocks, you can open Demat Account with the lowest fee and get investment ready with a fully digital KYC. Download the Paytm Money Stocks app today and build wealth with equities.