Stock Market Index
A stock market index is a statistical measurement of a section of the stock market. It measures the performance of a basket of stocks that are listed on the stock exchange and are grouped to replicate the performance of the market.
To form an index, the criteria for selection of stocks could be based on the size of the company or a particular industry or the market capitalization of the company. The value of the index is calculated based on the values of the underlying securities that constitute the index. The value of a given index varies according to the change in the value of the underlying stocks.
Indices serve as a benchmark against which the performance of a particular stock or a portfolio is evaluated.
Why are stock market indices needed?
A stock index reflects the market sentiment and direction of the price movements in financial, commodity, or any other markets. Investors consider the stock market index as a reference to identify the general patterns of the market.
You can also read Stock Market Indices in India
How are the values of the indices determined?
An index is derived from the value of a basket of stocks that are similar in terms of market capitalization or type of industry or the size of the company.
The index value is calculated from the value of its constituent stocks. It is important to note here that the price change is one of the constituent stocks will not be proportional to the price change of another constituent stock. So, the index cannot value cannot be derived by just summing up the prices of its constituent stocks.
To determine the index value, each of the constituent stocks is assigned a particular weightage based on its market capitalization or price. The weightage indicates the extent of the impact a stock’s price change can have on the index.
There are two most popular methods of forming an index:
Market Capitalization Weighted Index
Market Capitalization is the total market value of the stocks of a company. It is calculated by multiplying the total number of stocks floated by the company with the current price of the stock. It considers both the price and the size of the stocks.
In an index based on the Market Capitalization Weighted approach, the stocks are assigned weightage based on their market capitalization as compared to the total market capitalization of the index.
For example, if an index has a total market capitalization of Rs.10,00,000 and its constituent Stock A has a market capitalization of Rs.1,00,000. Then, the weightage given to Stock A will be (1000000/100000) = 10 which is expressed in percentage as 10%.
Price Weighted Index
In an index based on the Price weighted approach, the value of the index is calculated based on the price of the stock constituting the index. In this type of index, each company constituting the index makes up for a fraction of the index in proportion to the price of its stock.
In this, stocks with higher prices received higher weightage as compared to those with lower prices.
Why do we need a Stock Market Index?
The stock market index acts as a yardstick to gauge the overall conditions of a market. It guides the investors to decide on the stocks they are going to invest in.
Below are some of the reasons why a stock market index is important:
- Helps in Stock picking
There are thousands of companies listed on an exchange. For an investor, it becomes difficult to choose a particular stock for investment. An index will help the investor to differentiate the stocks based on the size of the company, type of industry, sector, etc.
- Acts as a parameter for peer-peer comparison
When the investor has to choose to pick a stock between two similar companies, he can compare the performance of the stocks with that of the index. The one which has given returns more than the index is said to have outperformed.
- Shows investor sentiment
A stock market index also reflects investor confidence and sentiments about the performance of a particular stock. When the investor mood is positive, the demand for a particular stock increases which in turn increases its price. If the stock is one of the constituents of the index, the value of the index also rises.
- Helps in passive investment strategies
Passive investment refers to investing in a portfolio of stocks which replicates the constituent stocks of the index in the same weightage. The returns of such portfolios will be on par with the index. For beginners and for those who lack time and skill for research, it is an efficient way to invest.