People often turn to stocks to build wealth in the long run. Even for goal-based investing, many investors turn to equities. But, stock markets are volatile and tend to fluctuate minute by minute. These fluctuations can be because of different factors, ranging from news and company announcements to market sentiments. So, how can traders and investors understand the general sentiment of the stock market? Monitoring stock indices is one way to go.
Market indices are a reflection of all the factors that impact the general market. They can be used to gauge the health of financial markets and even the nation’s economic condition. A rational investor will always monitor stock market indices before making investment decisions.
What is a Stock Index?
When a company wants to do quality testing on one of its products, say a basket of oranges it has harvested, it does not really check every single orange. Instead, it selects a sample and rates the quality of oranges in that sample.
Similarly, a stock index consists of a basket of securities from a particular segment or sector that acts as a representative for that sector. Monitoring the performance of a sample of companies can give you a good idea of how that particular segment is performing. This curated list of companies based on homogenous factors is a stock index. Each of the companies in the index are called index constituents.
There can be different kinds of stock indices in the market. Broad market indices capture the performance of an entire market. They are composed of companies from multiple sectors. Nifty and Sensex are the two broad-market indices in India.
A sector-specific index is composed of companies from a specific sector. For instance, the Nifty Bank index represents the banking sector in India while the Nifty Pharma index represents the pharmaceutical sector in the country.
A stock index is a good indicator of the market health, be it overall market health or the health of a specific sector.
What is the Use of an Index?
The primary use of an index is to serve as a benchmark for the stock market. Investors and traders follow a stock market index to make investment decisions and manage their investment portfolio. They may also use an index to make investments in certain sectors depending upon how the index is performing.
Stock market indices are also used by mutual fund managers and ETFs to make investment decisions that beat the market. When someone says they have “beat the market”, it is usually in comparison to how an index has performed.
They are also useful for passive investing. An investor who does not want to spend time picking individual stocks can mimic the composition of a stock index and invest accordingly. Alternatively, if you want to invest in an index without investing in each stock yourself, you can also choose to invest in an index fund.
How Is an Index Constructed?
An index can be constructed in different ways depending on how investments in each index constituent is made. Usually, the process involves:
- Selecting the criteria for the index – is it a broad market index or a sector index?
- Choosing the right companies to include in the index such that they are the right representative of the market
- Choosing how to allocate weights to each constituent
Choosing weights for an index is important because it determines how much value a particular constituent will have in an index. For instance, the Nifty50 index has 50 constituents across 13 sectors in India. Reliance Industries Ltd. has the largest weightage based on its market capitalisation.
The weights of index constituents are decided based on the kind of index it is. These are the three main ways to construct an index:
- Capitalisation-Weighted Index
A market-cap weighted index invests depending on the market cap of a company. The higher the market cap of a company, the more weight it will have in an index. In India, the BSE Sensex and NIFTY are both market-cap weighted indices.
- Price-Weighted Index
A price-weighted index allocates more weight to companies that have higher prices. The Dow Jones from the US is a price-weighted index.
- Equal-Weighted Index
As the name suggests, an equal-weighted index is one in which all the constituents have equal weights. This is also called an unweighted index. The S&P 500 Equal Weighted Index, a derivative of the S&P 500 Index, is an example of an equal-weighted index.
How to Trade using an Index?
Trading involves buying and selling securities in the short term to turn a profit. If you want to trade in an index, here’s what you can do:
You can buy index scrips, the most straightforward way to trade an index. You need to buy and sell the index or buy and sell index constituents in the same weightage as the index.
You can trade in index futures or index options.
How to Invest using an Index
Investing refers to taking a position in a security for the long term. You can invest in indices in the following ways:
Index mutual funds
There are mutual funds that invest in stocks based on a particular index. You can gain exposure to an index by investing in a particular index mutual fund.
Exchange-traded funds are like mutual funds that can be traded on a stock exchange. You can invest in an index ETF that trades like stocks instead of investing in a mutual fund.
The Benchmark Stock Indices in India
As mentioned earlier, there are two benchmark indices in India – Nifty50 and Sensex.
What is Nifty50?
Nifty, a portmanteau of the words National and fifty, is a stock index that represents stocks listed on the National Stock Exchange. It consists of the top 50 stocks of the 1,600+ stocks that trade on the NSE. The Nifty50 has stocks picked from 13 different sectors in the economy. It is a free-float market capitalisation index, meaning weights are assigned based on the market cap of the company. The Nifty value is calculated on a daily basis.
What is Sensex?
Sensex is a portmanteau of the words Sensitive and Index. It consists of the top 30 stocks listed on the Bombay Stock Exchange. It is the oldest stock index in India. Like the Nifty, it is also a free-float market capitalisation index. It is often considered a good indicator of the performance of the Indian stock markets.
History of Sensex and Nifty50
Sensex is the oldest stock market index in India. It was launched on 1 January 1986. The name Sensex was coined by stock market analyst Deepak Mohanti. Four years after it was formed, the index touched the four-digit mark for the first time, closing at 1,001 in July 1990. On 11 February 2000, the IT boom pushed Sensex to its all-time high of 6,006 points. This was the highest it climbed for another four years. In February 2013, Sensex tied up with Standard & Poor to become S&P Sensex. It is now trading at 60,000 levels.
The Nifty50 index was launched on 22 April 1996. It borrowed its name from the Nifty Fifty index that was popular in the US during the 1960s and 1970s. The NSE Nifty50 began with a base value of 1000. Since then, its value has soared. In 2000, it touched 1,800 on the back of the IT boom. In 2006, it surpassed 3000 levels as the service sector in India grew. In 2014, a stable NDA government led to Nifty zooming to 7000. Following the GST rollout in 2017, it touched the 10,000 mark. Today, it trades at 17,000 levels.
How is Nifty50 Calculated?
Nifty is calculated using the free-float market capitalisation weighted method. The market value of each stock in the index is relative to the base period of 3 November 1995. Here’s how the Nifty is calculated:
- Start with computing the market capitalisation of each stock.
Market Capitalisation = Current market price * Outstanding shares
- The next step is to calculate the free float market capitalisation.
Free Float Market Capitalisation = Shares outstanding * Price * Investable Weight Factors (IWF)
IWF is a number that depicts what portion of a company’s total shares is available for free trade on the stock exchange.
- Then, the index value is calculated.
Index Value = (Current Market Value / Base Market Capital) * Nifty Base Index Value (1000)
How is Sensex Calculated?
Sensex is also a free-float market capitalisation index. Here are the steps to calculate free float market capitalisation:
- The market capitalisation of the 30 companies in the Sensex is calculated. The formula for calculating the value of the Sensex index is as follows:
(Free float market capitalisation of 30 companies / Base market capitalisation) * Base value of the index
- The base period (year) used here is 1978-79 and the base value is 100 index points.
Key Differences Between Sensex and Nifty
- The benchmark index for the Bombay Stock Exchange (BSE) is the Sensex, while the benchmark index for the National Stock Exchange (NSE) is the Nifty.
- The Sensex, which was established in 1986, consists of 30 representative stocks from various sectors of the Indian economy. In contrast, the Nifty, which was established a decade later in 1996, consists of 50 stocks that represent 13 different sectors of the Indian economy.
- As the oldest stock index in India, the Sensex has a long and storied history. It was first calculated on January 1, 1986, and has since become one of the most widely followed and respected indices in the world. On the other hand, the Nifty50 index came a decade later in 1996.
- When an index is created, a base value is selected to act as a benchmark. For the Sensex, this base value is 100, while for the Nifty, it is 1000. This base value serves as a reference point against which changes in the index's value can be measured. In other words, when the Sensex of Nifty goes up or down, it is expressed as a percentage change from this base value.
Here’s a quick representation of how the indices are different from each other.
Popularity of Sensex vs. Nifty50
Now, you may wonder which is the better index to follow, especially when it comes to trading or investing yourself. Financial experts usually do not distinguish between Nifty and Sensex. Both are considered equally good indicators of the market. Moreover, many of the companies overlap in both indices.
However, the trading community comprising intraday traders, mutual fund managers and hedge fund investors, tends to track Nifty more often since it covers a wider list of companies and sectors. Nifty tracks 50 companies while Sensex tracks 30. Nifty also gets indicators from SGX Nifty which trades in Singapore. On the flip side, Sensex is still popular among retail traders.
Choosing the Best Products
When choosing an index-based fund or an ETF to invest in, there are two things you need to consider – tracking error and expense ratio. Tracking error measures the difference between the actual return of the fund and the benchmark index’s performance. Expense ratio reflects the money it takes to run the fund.
- A stock index is a list of companies from a specific sector or the entire market that is representative of the market.
- The two most common types of stock market indices are broad-market indices and sectoral indices.
- Broad market indices capture the performance of an entire market. They are composed of companies from multiple sectors.
- A sector-specific index consists of companies from a specific sector and tracks the performance of that sector.
- Stock market indices are used as benchmarks for market performance, to make investment decisions and construct portfolios and to measure performance of mutual funds and ETFs
- There are three ways to construct an index:
- Market capitalisation-weighted index
- Price-weighted index
- Equal-weighted index
- The two benchmark indices in India are Nifty and Sensex
- Nifty50 is a broad-based index that tracks the top 50 companies listed on the National Stock Exchange
- Sensex is a broad-based index that tracks the top 30 companies listed on the Bombay Stock Exchange. It is the oldest index in India.