An index is a sign or measure of something. It is a statistical measure of the changes in basket of stocks representing a portion of the overall market. In simple terms, it’s a benchmark created to measure the changes in the price movements of the stocks in a portfolio.
It will be difficult to track the performance of each stock across various sectors; therefore, benchmark is a set from different sectors called as “index” where we can track the performance of the overall stocks by looking at the index.
Let me give you an example of BSE Sensex where it selects 30 stocks in its portfolio. The selection is based on different criteria’s. The main reason for choosing 30 stocks out of 5500+ stocks over different sectors is to get better understanding of the economy. Tracking these stocks individually will be impossible for anyone to analyse the trend in the economy, therefore they go with construction of index having 30 stocks. The change in the price of stock index is measured with reference to a base period.
If the indices are growing then it would indicate that the economy is doing good considering better government policies, corporate governance and the financial health of the company and if there is a slump in the index then this would indicate some of the sectors not performing well.
Indices are useful in many ways such as:
Stock market indices are the barometer for the stock market.
It helps the analysts to understand the trends in the market
It helps an active investor to diversify its funds rationally.
Gives a glimpse of the performance of the economy.
Types of Indices
There are different types of indices which are constructed as per the relevance. Some of them are
Based on Market Capitalization (E.g. BSE Small Cap, NSE MIDCAP)
Based on Broad Market (E.g. BSE 500, CNX100)
Based on Free Float Market Capitalization (E.g. BSE Sensex, Nifty50)
Based on Sector/Index (E.g. S&P BSE Metals, S&P BSE Auto, S&P BSE Metals etc)
The motive of construction of index is same for any type of indices. There are various micro and macro factors from which the performance of index can be measured.
These indices provide a benchmark for measuring the performance of the fund managers and analysts who are handling the portfolios for HNI’S, Mutual Funds, FII’s, Financial institutions or retail investors. Indices are usually useful for understanding the price movements and trends in the market. For E.g. One of them could be the Brexit event in Europe, which showed a bearish trend in global and Indian indices. Other is the FED rates which they release every quarter, which would show uptrend or downtrend in the indices.
Construction of Index
An interesting point of how does the index get constructed. There are many ways of constructing an index such as
Free float Market Capitalization Method
Market Capitalization-weighted method
In the next series of blogs, I would be focussing on the methods of how Sensex and Nifty are calculated.
In the end, Stock market index acts an indicator of the performance of the economy or sector of the economy. We can use global indices to analyse the trend in the foreign market and what implications can happen to the Indian market. Stock Indices runs also as per market sentiments along with technical and fundamental analysis.