Investors often face a dilemma when investing in securities such as stocks. How do you know how the market is performing or how do you grasp the performance of a specific sector?
This warrants the understanding of a market index, which can help you analyse the performance of the entire market or specific sectors to ensure better investing decisions.
What is a market index
A stock market index is a collection of various stocks of specific companies that provides an approximate idea of the market trend and performance. Market trend is a concept that allows investors to know the general direction of the stock market, whether it is in a bear run or a bull run. Stock market indices are created to gauge the overall market's performance or the performance of a specific sector. For example, an index called Nifty 50 contains stocks of the largest Indian companies and is managed by NSE indices.
Similar to the Nifty 50, there are various other stock market indices such as BSE Sensex, Nifty Bank, and Nifty Next 50. Every stock market index is responsible for tracking the performance of the shares it contains. Some stock market indices derive their values from the stock’s market capitalisation, fundamental weighting, float weighting, and revenue weighting.
Also read: commodity market timings
Understanding a market index
A market index is one of the most important tools for analysing the performance of the market or a specific sector. The Indian stock market has thousands of stocks listed on the stock exchanges, making it highly difficult for an investor to understand how the market or a specific sector is performing.
For example, if you want to invest Rs. 10,000 in banking stocks, there are hundreds of bank stocks listed on the stock exchanges. Based on their individual technical and fundamental factors and the general market trend, some may see a price decline, while some may see their prices increase drastically. In such a case, it becomes difficult for you to understand if the banking sector is performing well or is consolidating (witnessing a bear run).
A market index called Nifty Bank is the ideal solution for you here. Nifty Bank contains large capitalised—and most liquid—banking stocks, making them the ideal banking stocks to invest in. For your plan to invest Rs. 10,000 in a banking stock, you can look at the recent performance of the Nifty Bank index. If it has been performing well recently, it would indicate that the entire banking sector is performing well. However, a market index indicates the overall performance, and it is important to research the stock based on its technical and fundamental factors.
One of the best features of a market index is its tradable nature. You can buy units of a market index similar to buying shares. For example, you can buy 100 units of Nifty 50, and your investment will have a specific weightage for every stock that the market index contains. Based on the combined performance of all the contained shares, the price of the market index fluctuates.
Also read: SME IPO
The methodology of market indices
A stock market index uses the weighted average method to make its index calculations. The weighted average is a method that emphasises the varying degrees of importance of the stocks rather than adding them to the market index equally. For example, if you invest Rs. 10,000 in Nifty 50, you will not get equal weightage of all the 50 shares. Based on a company’s market capitalisation, different weights are assigned to every contained stock. If a stock in Nifty 50 has 10% weightage, 10% of the overall performance of the market index can be attributed to that stock.
Types of market indices in India
Here are the types of market indices in India:
- Benchmark indices: Benchmark indices indicate the performance of the entire stock market rather than specific sectors. Nifty 50 and Sensex are benchmark indices in India.
- Sectoral Indices: Sectoral indices indicate the performance of specific stock market sectors, such as banking, infrastructure, pharmaceuticals, etc. Nifty Bank and Nifty Pharma are some of India's sectoral indices.
- Market cap indices: Market cap indices contain stocks of companies based on their market capitalisation (mid-cap, small-cap, etc.). Some of India's market capitalisation indices are the NSE Smallcap 50 and Nifty Midcap 100.
Also read: Face value and market value
Products based on market indices
Mutual funds are one of the most popular products that have a category called Index funds. Index funds pool investors' money and invest in the same stocks as a market index. It is used to track the performance of a specific stock market index to provide better returns to investors. The market index that an index fund tracks is called the benchmark, and every index fund lists the details of the benchmark that it will track in its prospectus.
For example, if an index fund plans to track the performance of Nifty 50, it will invest your money in the same 50 stocks contained in the index with the same weightage.
Conclusion
A market index is a collection of stocks or any other underlying asset representing the overall market's performance or performance of specific sectors. It allows investors to understand the current market trend without having to analyse thousands of stocks. Benchmark indices, sectoral indices, and market cap indices are the main types of market indices in India. Now that you know what a market index is, you can grasp the market's performance more effectively.
