MarketsmithIndia Articles

Stock Market Index - Overview, Types, Importance

November 12 2021 | Reading Time: 5 Minutes
What is a stock market index?
To gain a better understanding of a stock market index, one needs to understand two terms: stock and stock exchange.
There are thousands of companies in every country. Many of these companies raise the capital required for their operations by issuing shares to the public. A group of shares forms a stock. By owning a stock, an investor partakes in the ownership of the company.
The public platform through which shares or stocks are bought or sold is known as stock exchanges. In India, the Bombay Stock Exchange and National Stock Exchange are the two major stock exchanges.
A stock market index comprises a group of stocks, listed on the exchange, that fall under a similar category. It is representative of the overall stock market and is a standardized measure to monitor changes in the stock market. Furthermore, indices aid in tracking the economy of the world, country, or a specific sector or industry group.
Any change in the stocks is reflected in the performance of the index. Surging stock prices lead to the rise of the index while dropping stock prices causes the index to tumble. Thus, stock market indices help investors track the changes in the general market direction. 
How to Calculate the Value of an Index?
There are several ways used to calculate the value of a stock market index. Let’s take a look at two common methods: Free-float market capitalisation method and price weightage.
1.Free-float market capitalisation method:
In this method, the current value of an index is the sum of free-float market capitalization of all stocks listed in the index divided by the base year index value.
Free float is the number of shares of the company that can be freely traded. Free float, divided by the total shares, gives the company’s free float factor. The free-float market capitalization is the product of the stock’s market price, the total number of shares, and the free float factor or simply, the share price multiplied by the free float of the company. 
Assume an index has stocks of companies A, B, and C.
Suppose in company A:
Free float - 100 shares
Total float - 200 shares
Free float factor = 0.5
Free float market capitalisation (A) = share price of A x 200 x 0.5 
or simply, share price of A x free float
Similarly, calculate the free float market capitalisation for stock B and stock C.
Then, total free float market capital of index:
Free float market capitalisation (A) + Free float market capitalisation (B) + Free float market capitalisation (C)
Assuming the base index value was 100 and base free float market capitalisation of the index was 5000, the current value of the index will be:
 Total free float market capital of index x 100
The values of indices like Sensex and Nifty are calculated using this formula.
In these indices, the stock weightage is based on the free float market capitalisation. Companies with higher free float have more impact on the index, are less volatile, and generally more preferred by investors than those with lesser free float.
2.Price weighted index:
The value of the index is obtained by dividing the sum of stock prices of each stock by the divisor, an arbitrary value assigned by the index. The value of the divisor is subjected to changes based on structural changes within the index.
Dow Jones Industrial Average uses this methodology. Each stock in the index is assigned its weightage based on its price. Higher the stock price, higher the weightage and greater the impact of its price changes on the index.
Types of Stock Market Indices
The stocks in an index are grouped based on different factors, including the company’s industry group, geographical region, the company size and market capitalization. In India, stock market indices are mainly of four types:
1.Benchmark indices: Stock market indices, like BSE Sensex and NSE Nifty, contain the top performing stocks of leading companies that drive the growth of the country’s economy and hence often serve as benchmarks, to gauge the overall performance of the general market.
2.Sectoral indices: Indices, such as Nifty Auto, Nifty Bank, and Nifty FMCG, that serve as benchmarks to measure the performance of stocks of a particular industry group or sector. Furthermore, you can compare how a stock performs with respect to others within the same sector.
3.Market capitalization-based indices: As the name suggests, these stock market indices are based on the market capitalization of the company. Example: BSE Smallcap and BSE Midcap.
4.Broad market indices: These indices include large, liquid listed stocks. Example: Nifty 50 and Nifty 100 which contain stocks of the country’s 50 and 100 largest companies, respectively.
Major Stock market indexes
Although there are many functioning stock markets across the globe, there are a few that are well known. But, the three most widely followed indexes are S&P 500, Dow Jones Industrial Average, and Nasdaq composite. When it comes to major stock market index in India, BSE Sensex and Nifty are the major ones. There are other stock market indexes such as Nifty Junior and NSE CNX MidCap.. 
Importance of Stock Market Indices
Serve as a benchmark and help assess competition:
Picking up the right stock can be difficult without a benchmark to assess the performance of individual stocks. Market indices, through the classification of stocks based on various factors, serve as this benchmark. 
Potential winning stocks tend to outperform the other stocks in their respective index. Thus, indices also help to assess the competition.
Evaluates risk:
Stock market indices have vast information about their listed stocks, such as price and volume changes, which can help investors decide if investing in the stock is risky and, if so, worth the risk. 
Since an index comprises similar stocks, it provides the performance overview of a particular stock category or sector. Hence, evaluating the risk associated with investing in a particular sector is also made easy through monitoring the performance of the index.
Signals investor sentiment:
Investor sentiment drives the stock price changes. Stocks favored by institutional investors see a rise in demand and subsequently, an increase in the price. Monitoring the performance of a stock market index can help you as an investor gauge the investor sentiment toward the particular sector and general market as a whole.
Aids in passive investment:
Stock market indices help in developing index funds that are used in passive investments. In a passive investment, the investor’s goal is to obtain portfolio returns that are similar to that of an index. To achieve this, the investor chooses to build and invest in a stock portfolio that mirrors the index itself, commonly known as index funds. 
1.What does a market index do?
A stock market index helps investors measure the changes in the general market. It serves as a benchmark to assess the performance of stocks, helps evaluate the risk involved in investing in a particular stock, and aids in gauging the investor sentiment toward a particular sector or the overall general market. 
2.What are the major stock market indices?
The two major Indian stock market indices are BSE Sensex and NSE Nifty.
  • BSE Sensex, created in 1986, is India’s first equity index. It comprises the country’s top 30 companies and is one of India’s benchmark indices. 
  • NSE Nifty, created in 1996, comprises India's top 50 companies and also serves as one of the country’s benchmark indices.
3.What is the biggest stock index?
NSE Nifty is the biggest Indian stock market index.
4.How do I find a stock index?
The details of the stock index and those of the stocks listed within the index are accessible to the public through the index’s website.

5.How do I find stock codes?
Stock codes or ticker symbols are a unique combination of letters and numbers assigned to listed stocks. These codes can be found in financial news or investment websites.

What do you think? Please email us any questions or comments.

Disclaimer: Information contained herein is not and should not be construed as an offer, solicitation, or recommendation to buy or sell securities. It is for educational purposes only.For more information, see our Legal disclosures here.

Related Article