The stock market is a huge financial market that helps businesses make way for financial resources, individuals invest for long-term benefits, and others tend to make short-term gains. But, there has to be a basis on which the individuals or businesses analyse the stock market’s movement. And the basis here is defined as the Stock Market Index.
Published on 11 April 2022
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Like how the traffic of a big city is understood based on some of the most important junctions, you can understand the market sentiment and the movement of prices based on the prominent stocks of certain industrial leaders.
What is the Stock Market Index?
The stock markets index is a statistical figure that provides an insight into the trends of the stock market and the investor sentiment towards some of the most important stocks. Therefore, it can relate to the stock market price changes. Some of the similar stocks amongst the listed securities are chosen and grouped.
The criteria for grouping will be based on the type of industry, market capitalisation, etc. And the stock market index will derive the value from its underlying stocks. Therefore, if the prices of all the underlying stocks increase, the value of the stock markets index will also rise.
Indices based on market capitalisation - BSE Midcap, BSE Smallcap
Broad-based indices - BSE 100, Nifty 50
How is Stock Market Index Developed?
The stock markets index is evaluated by grouping stocks based on the company's market capitalisation, industry, and size. After selecting the stocks, the value is calculated. Therefore, the index's performance cannot be attributed based on the sum of stock prices.
Every stock will have a different price, and any change in the price will not be proportionally equal to another. Therefore, assigning weights to individual stocks becomes essential. Every stock will have an individual weightage assigned based on the size or market capitalisation. The weight will represent the extent of impact established by the particular stock on the index value.
There are two ways to determine the weightage:
Market capitalisation - The free-float market capitalisation is the most common method to decide weightage. For instance, if the stock's market capitalisation is ₹25,000 and that of the index is ₹1,00,000. Then, the weightage of the stock will be 25%.
Price - The index value here is determined based on the prices of individual stocks. The stocks having a higher price will have a higher weightage in the stock market index.
Why is the Stock Market Index Required?
The stock markets index and its value are of great interest to all investors. It is required for many reasons.
Becomes a representative for information about a sector - Investing in the stock markets requires analysing the risk factors. Evaluating individual stocks requires a lot of time and effort. As the indices represent the particular stock market sector's trend, it details the individual stocks' performance and fills the knowledge gap. Therefore, the index made of automobile stocks will represent its stock price movements.
Benchmark and a parameter for comparison - Investors tend to choose stocks that outperform the index. You can compare the stock's performance based on the underlying stock index. For example, you have chosen a stock that provides a 20% return in a financial year. How do you evaluate your performance? If you can trace the movement of the Nifty points giving a 25% return, it means you have underperformed compared to the Nifty index.
Realise investor sentiment - The stock market index can reflect investor sentiment. Knowing the investor sentiment is important because it will help you understand the demand for the stocks that will determine the price movement. Moreover, you can compare the investor sentiment across different market capitalisations and sectors to understand the rise and fall of prices and judge the stability of the stocks.
Helps in picking the right stock - There are different types of stocks in the securities market. Sorting the most appropriate ones can be an arduous task for any investor. Benchmarking can help differentiate the stocks for investment decisions. The stock market index will help differentiate the stocks based on the industry, size, sector, etc., and becomes an instant differentiator to help you make a wise decision.
Offers an investment portfolio - Busy professionals who cannot spend time on effective research for investment do invest in index stocks. So, if your portfolio depends on the Sensex index, you will receive a 7% return if the Sensex value earns a 7% return.
Conclusion
The stock markets index is one of the most important parameters to evaluate the stock market trend based on market capitalisation, sector, and size. There are two different ways to determine the index value, market capitalisation, and the price. It can help judge the stock demand, prices, and investor sentiment. In addition, the index value represents the value of every sector, helps investors compare their performance, and aids in picking the right stocks. Understand the importance of the stock market and its relevance in realising the trend to make the most informed decisions.
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Indices are an excellent source of information. By looking at the index value, one can understand whether the market is moving in an optimistic or pessimistic direction. The value of the indices holds an important place in economic research. It reflects up-to-date information and is also a benchmark to measure the performance of fund managers.
An investor can create a portfolio that will provide the same returns as the index. For example, if there is an index with three stocks assigned weightage as 25%, 25%, and 50%, respectively. If you form a portfolio investing ₹1,00,000 by purchasing the stocks spending ₹25,000, ₹25,000 and ₹50,000, same as the weightage, then the returns from the portfolio will mimic the index's returns. If the index earns 5% returns, your investment will also increase by 5%.
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An investor can create a portfolio that will provide the same returns as the index. For example, if there is an index with three stocks assigned weightage as 25%, 25%, and 50%, respectively. If you form a portfolio investing ₹1,00,000 by purchasing the stocks spending ₹25,000, ₹25,000 and ₹50,000, same as the weightage, then the returns from the portfolio will mimic the index's returns. If the index earns 5% returns, your investment will also increase by 5%.
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