A stock market index is a mathematical construct. It comprises a group of stocks that are strategically selected to represent the entire pool of listed stocks in the stock market. With over 7400 stocks and assets listed on the 7 stock exchanges in India (the most popular of which are the BSE and NSE), it is nearly impossible to track the growth of each asset separately. This representation of a bunch of stocks that form an index gives context and sets a benchmark for a measure of performance of the assets. Let’s study this in detail.
This article covers:
- What is an index?
- Importance of a stock market index
- Types of stock market indices
- Can you invest in stock market indices?
What is an index?
An index is a basket of top-performing stocks selected from different market sectors that acts as a mirror of the performance of the market as a whole. While it would be an arduous task to track multiple stocks at once, an index gives you the ease of gauging the performance of a particular stock against the benchmark index. The Nifty is the benchmark for the stocks listed in the NSE and the Sensex acts as the benchmark for stocks in the BSE.
The grouping of the companies to form an index can be based on sectors, market capitalization, and market strategies too.
Importance of a stock market index
Index majorly represents market mood. The index reacts to electoral, political, and geopolitical events, mirroring the sentiment in the market. Besides this, the following explains the importance of an index.
Helpful in stock selection for investment
With over 7000 listed companies, it is complicated to make stock picks to add to a portfolio without a comprehensive view of the performances of the sector and industry apart from individual stock.
The stock market index acts as a differentiator and groups stocks in an organized manner based on classification criteria. This criterion could be—market cap, sector, industry, company type, etc. For example, Nifty IT is a collection of the top 10 companies from the IT sector. Grouping similar stocks in an index makes it easier for investors to draw a comparison and measure performance against the markets.
Acts as representative
Major stock indices Sensex and Nifty are traditionally used by all investors to understand the market mood and sentiments on a whole. Similarly, a sectoral index movement reflects the direction of the particular sector.
For example, the Nifty Pharma that represents the pharmaceutical sector displayed a rising trend during the peak of covid. However, the number of very large pharma companies (by market capitalization) is fewer and therefore, changes in Nifty Pharma does not have as much impact on the Nifty 50 itself as the heavyweight Nifty IT or Nifty Bank. Hence, an index can be read separately or in relation to each other too.
Indices serve as a dependable point of reference against which one can compare the performance of stocks before investing. This enables you to find out the performance of the stocks against the benchmark index, its performance in comparison to other companies in the sector, the performance of the entire sector, etc.
For example, if you wish to invest in the banking sector, you may assess Nifty Bank and find out which stocks have outperformed the benchmark index or have a greater stock valuation, which one is doing better in terms of liquidity, etc.
Types of stock market indices
Talking about India, we have the following types of indices:
Benchmark indices: Indian stock market is synonymous with Nifty and Sensex. BSE Sensex with 30 companies, and NSE Nifty with 50 companies, are the two benchmark indices.
Sectoral indices: These indices account for different sectors of the Indian economy. The idea here is to group stocks belonging to the same sector under one index. Some examples are Nifty PSU bank, Nifty IT, Nifty Metal, BSE PSU bank, etc.
Market capitalization based index: This index category consists of companies meeting specific market capitalization criteria. For example, NSE midcap 100, S&P BSE midcap, will consist of companies having a market cap exceeding Rs. 5,000 cr. but limited to Rs. 20,000 cr. Companies with a market cap of up to Rs. 5,000 cr will feature in BSE smallcap and NSE smallcap, while largecap companies that command over Rs. 20,000 cr. will feature on indices like S&P BSE largecap.
Can you invest in stock market indices?
It’s not possible for you to directly invest in stock market indices. But you can indirectly trade them through various investment products and strategies.
Recreating the index yourself: Probably the hardest of the methods, you can find out the composition of the benchmark indices and create your personalized portfolio assigning similar weights to the stocks as the benchmark index does. Though it’s quite an uphill task because it asks for periodic adjustments as the stock weightage in the indices keeps changing based on everyday traded price, and you may need to align your portfolio accordingly.
Trading futures contracts: The NSE commenced trading in index futures on 12 June 2000. Futures contracts are the derivative instruments you can invest in to gain exposure to the Nifty 50. They are called derivatives because they derive their values from the underlying asset. The index futures contracts are based on the popular market benchmark Nifty 50 index.
Investing in index mutual funds: Index mutual funds are one of the easiest and low-cost ways to gain exposure to indices. Index funds mirror the composition of the benchmark index that the mutual fund tracks in the exact same weightage too. They are passive funds and generate returns comparable to the index they imitate.
The stock market index represents selected stocks from all sectors, which can help analyse and gauge market mood and sentiment. They are several types of indexes, many catering to individual sectors. Of all, Nifty and Sensex are the most popular. These indices are majorly used for peer comparison and a standard measure of stock against the market.
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