Stock Market Index: Meaning, Types and How to Invest in It

The stock market is full of complex terminologies and shifting statistics. Understanding the fundamentals of the stock market and how it works can be quite beneficial for investors. One essential concept that all investors should understand is the stock market index. A stock market index represents the average value of some selected stocks. For instance, Nifty 50 index represents the average value of the top 50 stocks, in terms of market capitalisation, that are listed at NSE. A tracks the performance of a set of equities that represent a specific sector or the entire market.

This blog explains what a stock market index is, how it is calculated, why it is important, and how it can help investors make better decisions.

What is Index in Stock Market?

A stock market index is an instrument for tracking in the financial markets. It serves as an indicator of performance, showing how a specific section or the market as a whole is performing.

Stocks from similar companies or that match particular criteria are chosen to form an index. These equities have already been listed and traded on a stock exchange. The share market index can be generated using various criteria, including industry type, market segment, and company size. Certain indices, such as Sensex and Nifty 50, also represent the broad market.

Each index tracks the price fluctuation and achievement of its component equities. In simpler terms, when the value of the stocks in an index grows, so does the index itself.

Why are Stock Market Indices Important?

Stock market indices are primarily used to monitor and measure performance in individual sectors, fields, or the whole market. Now, let us understand the significance of the stock market indices.

• Make Stock Selections Simple

Because there are hundreds of stocks listed on the exchange without a benchmark, it is difficult to distinguish one stock from another. This makes investing tough. A stock market index helps to narrow down by classifying stocks based on sectors, industry type, company size, and other factors.

• Minimises Risks by Proxy Investments

One can get the diversification benefit by investing in the stocks that make up the broader index, and in the same proportion as the stocks are held in the index. Investments in stocks always come with risk. However, digging into every stock for reduced volatility is not a good solution. India’s benchmark indices, including NSE Nifty 50 and BSE Sensex, are ideal choices for passive investors who don’t want to take on the risk of making the wrong investment choices.

• Sets Evaluation Parameters

Before putting a stock investment in a portfolio, it is important to determine whether it is worthwhile. Comparing a stock to an index gives an understanding of its performance. For example, if a given stock generates higher returns than the index, the stock has outperformed its benchmark.

• Investor Sentiment is Apparent

Because numerous investors participate in equity markets, it becomes important to measure their sentiments. The index can give an idea of the broader market sentiment. If you want to invest in a particular stock, you must understand how the stock price fluctuates. Instead of keeping track of multiple stocks, you can simply monitor a stock market index.

How is a Stock Market Index Calculated?

The Indian stock market has two large-cap indices: the S&P BSE Sensex and the Nifty 50. Both of these indicators represent statistical aggregates of market performance. We all have heard news like “Sensex hit new record highs”.

Now, don’t you wonder how indices like the Sensex and Nifty are calculated? And how does that value reflect the companies included in the particular index? Well, let’s check it out.

Before we get into the computation, here’s what you should know:

• Each stock in an index is given a weight depending on its market capitalisation.

• The weight also shows the amount to which the stock price affects the index’s value

There are basically three steps to calculating an index value. This is how it’s done:

• Step 1: The market capitalisation of each firm in a stock market index is calculated by multiplying the price of its stock by the number of outstanding shares that are in free float. Market capitalisation is the total market worth of a company according to the total worth of its outstanding shares.

Market capitalisation = Total number of shares x Per share price

• Step 2: The second step involves calculating the free float factor, which is the market value of the holdings that are available for trade on the market.

Here’s how to calculate the free float market capitalisation using the free float factor.

The Free Float Market Cap = Total Number of Shares x Free float factor x Per share price

• Step 3: In this phase, the total free-float market capitalisation of all the index stocks is divided by a comparable total that was determined during the base period.

Current Index Value = (Current Total Market Value of Index Stocks/Total Market Value of Index Stocks as of Base Year) X Base Index Value

Let us simplify the process of how to calculate the stock market index with an example:

Let’s assume we are calculating the index value of the index “XYZ 3”, which includes the stocks of three companies: Company X, Company Y, and Company Z.

Total Free Float Market Capitalisation

• Base Date Total: ₹31,25,00,000
• Next Day Total: ₹33,52,50,000

Assume Base Year Index Value: 100

Current Index Value= (Next Day Total Market Capitalisation× Base Date Total Market Capitalisation Value) x Base Index Value= (33,52,50,000/ 31,25,00,000) x 100 = 107.27

With the above stock market index example, you will understand that the index value of ‘XYZ 3’ is precisely correlated to the weightage of fundamental companies and the associated changes in their overall market price.

This is how a stock market index depicts how the companies that are listed on it are performing.

How is a Stock Market Index Formed? 

To be a part of an index, a stock must meet specific requirements. For instance, the stock must have a minimum market capitalisation and trading volume or be in a specified sector. However, not all stocks in the index may carry the same weightage. Some equities have a greater weightage than others, which is determined by their market capitalisation or price compared to the total index.

The two most often used stock market indices are listed below: 

• Market Capitalisation Weightage

Market capitalisation is defined as the total market value of a corporation based on its stocks. It is computed as the product of the entire number of outstanding shares issued by the company multiplied by the price of each share. It consequently analyses the price and quantity of the share.

In a market-cap-weighted index, stocks are weighted based on their market capitalisation relative to the index’s total market capitalisation.

In India, most indices employ free-float market capitalisation. Market capitalisation is calculated without considering a company’s entire number of listed shares. Instead, we simply utilise the total number of shares accessible for public trading. As a result, it returns a lower number compared to the total market cap value.

• Price Weightage

In this method the weight to different stocks in an index is based on its price. Thus, stocks with higher prices receive more weightage in the index than ones that carry lower prices.

What are the Different Types of Stock Market Indices?

Now that you know the meaning of stock index, let us introduce its different types:

• Sectoral Index

Both NSE and BSE offer several excellent indicators for evaluating companies in a certain sector. Indices such as the S&P BSE Health and NSE Pharma are effective predictors of the country’s pharmaceutical industry.

Another example of a sectoral stock market index is the Nifty PSU Bank and S&P BSE PSU indices, which replicate the performance of publicly traded public sector banks. However, neither exchange is obligated to offer similar indices for all industries despite this being a major factor in general.

• Market Cap based Index

Some indices are weighted on the basis of the market capitalisation of the companies. Market capitalisation is the stock exchange prices of any publicly owned company. Indices like the S&P NSE small cap 50 and BSE are companies having a small market capitalisation, according to the SEBI (Securities Exchange Board of India).

• Benchmark Index

Indices also serve the function of acting as benchmarks while evaluating the performance of different investments. The Nifty 50 index, which includes the top 50 best-performing stocks, and the BSE Sensex index, which contains the top 30 best-performing stocks, serve as indicators for the NSE and the Bombay Stock Exchange, as well as the Indian stock market.

This group of equities is regarded as a benchmark index since they use the highest standards to govern the companies they choose. Therefore, these indices are considered the most trustworthy source of knowledge regarding how markets function in general.

• Other Indices

Several other indices, like the S&P BSE 500, NSE 100, and S&P BSE 100, are considerably bigger and have a greater variety of stocks featured on them. Indices like the Nifty Next 50 have specific investment criteria that let you focus on certain areas, like investment in top companies that may become a part of Nifty 50.

In addition, you can invest in global indices such as S&P 500, MSCI World, S&P Global 1200, etc. These allow you to diversify your investments internationally.

Hope you can comprehend how the stock market index works now. So, let us explore how to invest in it.

How to Invest in Stock Market Indices?

While indices cannot be exactly purchased (they are simply benchmarks), there are ways to purchase investments that replicate their performance.

• Indexing

The first approach for investing in an index is to attempt to mimic it yourself, a practice called indexing. This allows you to build your portfolio of stocks that best match an index. The stocks and weightage of your allocations would be identical to those in the actual index, and information about index components and percentage weightage is freely accessible on various financial or investing websites.

• ETFs and Index Mutual Funds

Index funds, especially index mutual funds, are an affordable way to replicate the market index. While index mutual funds do impose management fees, they are often much less than those charged by the average active mutual fund. Numerous companies provide index funds and other investment products.

Exchange-traded funds (ETFs) monitor a stock market index in the same way that index mutual funds do, but they are listed and traded on an exchange. You can purchase and sell ETFs just like any other security. An ETF’s pricing represents its net asset value (NAV), which consists of all of the fund’s securities.

• Index Futures 

A third technique to invest in an index is to purchase futures on the index.

“Index futures” are contracts (also called derivatives) in which two parties enter into a contract to buy or sell the index at a future date at a predetermined price. For the buyer if on the exercise day the value of the index is more than the agreed price, it will be a gain (and vice-versa). For the seller if the value of the index is less than the agreed price on the exercise date then it will be a gain (and vice-versa). Index futures are settled in cash. Index futures serve to speculate on how an index’s price will move. Traders and investment managers can also utilise index futures to protect their stock investments from losses.

Index futures, like all other futures contracts in general, allow the trader or investor the ability and assurance of cash value according to an underlying index on a specific future date. Unless the contract is pulled apart before its expiration via an offsetting deal, the trader is required to deliver the cash value after expiration.

Conclusion

A stock market index is more than just useful; it is essential. It makes investment safer and easier for businesses and investors. Indices ease the burden on traders by guiding them throughout the initial stages, making stock investments safer and more understandable.

Share market indices are critical resources for traders, analysts, and financial experts. Their impact goes beyond the finance industry and influences the overall economy and the public’s perception. However, there is a lot more to investment than simply following indices. Investors must look beyond the index and discover what meets their financial objectives and risk tolerance before taking any steps.