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Stock Market Index: Definition, How it Works, Types, and Popular Stock Market Indexes          

Stock Market Index: Definition, How it Works, Types, and Popular Stock Market Indexes

Stock Market Index: Definition, How it Works, Types, and Popular Stock Market Indexes

A stock market index is a collection of stocks that represent the overall stock market or a portion of it. A stock market index helps an investor in analyzing the health of the overall market or a specific segment of the market. 

A stock market index works by tracking the overall performance of its constituent stocks. The value of any market index is calculated by assigning a specific value to every stock in the index. The value given to stocks is decided by following a specific index weighting model. 

The stock market index works by choosing a set of stocks that suits the index’s underlying methodology. This helps investors and traders in keeping track of the whole stock market or a particular market sector.

Each stock market index tracks a market category. Broad market indices track market performance. S&P 500, Nifty 50, and Sensex are examples. Since they include a wide number of companies across sectors, investors and traders use these indices to evaluate market sentiment. Large-cap indexes follow large-cap stocks. These are often well-established, high-market cap enterprises.

This indicator shows market leaders’ performances. Mid-cap indexes track mid-cap equities. These minor enterprises have considerable market value. Mid-cap indexes show performance trends for smaller companies, which may have different growth possibilities or hazards than large-cap corporations.

What is Stock Market Index?

A stock market index is a collective measure of a group of stocks that represent a particular segment of the overall market. A stock market index is valued based on the collective performance of its underlying stocks. The value of these indices are calculated by using index weighting models such as market-cap weighting and price weighting model. 

Different stock market indices are built on different methodologies. For example, some indices only track technology sector while other indices track the FMCG sector. Nifty 50 and Sensex are two of the most primarily known benchmark indexes in India. 

“Stock index” is another term used while referring to a stock market index. The underlying meaning and use of both of these terms remain the same. 

The stock market indexes are of 2 types – 1) Investable index and 2) Transparent index. Investors use both of these indexes for different purposes. 

  1. Investable index – 

An investable index is an index which lets investors invest their money in it via ETFs and mutual funds. Investible index provides exposure to people wanting to invest their money into a particular market segment. It helps investors in reducing the time and effort required to analyze and pick individual stocks. 

  1. Transparent index – 

Transparent index offers investors transparency about its methodology for the selection of its underlying stocks. Transparent index helps investors in gaining a better understanding about the index and predicting the index’s performance in certain market situations.

The value of a stock market index is calculated by using a specific index weighting model. Following are 3 of the most common stock market index weighting models. Each of these models follow a different method for tracking the stocks – 

  • Market capitalization –   

Market capitalization is the most common index weighting model. In this model, companies having large market capitalization affect its index more than smaller companies. Investors calculate the market capitalization of each stock by multiplying its stock price by the number of outstanding shares. Calculate the total market capitalization of the index by summing the market capitalizations of all stocks in the index then.

The next step is to determine the weight of each stock by dividing its market capitalization by the total market capitalization of the index. Calculate the index value by multiplying each stock’s weight by its price, then summing the results for all stocks in the index, lastly.

  • Price weighting  –

Price weighting model puts emphasis on the price per share of a stock. In this model, each company’s weightage is determined by its price per share. Stocks having higher price impact the index more compared to stocks having lower price.

Sum up the stock prices of all the companies in the index to calculate. Determine the weight of each stock by dividing its stock price by the sum of all stock prices in the index. Lastly, calculate the index value by multiplying each stock’s weight by its price, then summing the results for all stocks in the index.

  • Equal weighting  – 

In this model, each and every stock has the same weightage and the same ability to impact the overall index regardless of its market capitalization and price per share. Assign an equal weight to each stock in the index for calculation. For example, each stock will have a weight of 1% if there are 100 stocks in the index. Calculate the index value by multiplying each stock’s weight by its price, then summing the results for all stocks in the index.

Beginner investors often get confused between ETFs and the stock market index. Both are different instruments and serve different purposes. A stock market index is a collective measure of the performance of its underlying group of stocks. It is only used to track the performance of its underlying stocks. However, ETFs are investment instruments that can be traded as stocks.

An ETF also tracks the performance of a particular market sector by mirroring the performance of any given stock market index. But unlike market index, Investors can invest their money into an ETF. ETFs offer investors an opportunity to invest in the broad market rather than investing in individual stocks. 

How does Stock Market Index function?

A stock market index tracks the performance of its underlying portfolio of stocks. Every stock market index follows a certain methodology. An index’s collective value is calculated by using an index weighting model. For example, S&P 500, the most widely used stock market index, uses a market capitalization model. Meaning, S&P 500’s performance is largely dependent on its underlying stocks having a huge market capitalization. 

Following are the 3 major uses of a stock market index – 

  1. Tracks the performance of market as a whole – 

A stock market index enables the investors to track the performance of the broader market or a specific market segment. Investors can also use this information to evaluate the performance of their own portfolios compared to the broader market. 

  1. Tracks market sector – 

A stock market index is also used to track the performance of a specific market sector. It makes the process of investing in a particular market sector much easier for the investor. 

  1. Helps in developing a trading/investment strategy – 

A stock market index provides a hassle-free way of investing in the broad market. With the help of a stock market index, an investor can invest in a portfolio of stocks rather than analyzing and choosing an individual stock. This helps an investor in diversifying his portfolio and thus reduces the risk involved in investing. 

A stock market index is also looked upon as a benchmark for analyzing the health of a particular nation’s economy. This data helps an investor in assessing the value of his/her portfolio by comparing it to a benchmark index. 

 In short, a stock market index fulfills its purpose by providing the necessary data required by investors and financial analysts for tracking the broader market. 

What are the Types of Stock Market Indexes?

There are different types of stock market indexes made for tracking different types of market sectors. Following are the 4 broader types of stock market index. Each index varies in their underlying methodologies and their weightage model is different also.

Types of Market Indexes by Stock

Indexes by market capitalization are the indexes that are weighted based on market capitalization of their underlying stocks. Most types of indexes use market capitalization as a weighting model. The value of these indexes is heavily dependent on its underlying stocks that have a higher market capitalization.

These indexes provide a much clear picture of the overall market and helps an investor in taking informed investment decisions. Most famous example of an index which uses market capitalization as its weighting model is S&P 500. 

Types of Market Indices by Coverage

Indexes by coverage are the type of indexes that only track a particular market segment. Indexes by coverage do not track the whole market. These indexes help investors in diversifying their portfolio into a specific market segment. It also helps investors in evaluating their own portfolios compared to a particular market segment. A widely known example of index by coverage is The MSCI World Index. 

What are the most widely used world Stock Market Indexes?

The most widely used stock market indexes in the world are generally indexes that attract the highest number of volumes. Following are 5 of the most widely used stock market indexes in the world. 

  1. S&P 500

The S&P 500 was introduced in the year of 1957. S&P 500, also called the Standard & Poor’s 500, measures the performance of the top 500 U.S. based companies. S&P 500 is viewed as the primary indicator which shows the overall health of the U.S. economy. This is why, S&P 500 is one of the top 5 stock market indexes in the world. 

S&P 500
S&P 500

S&P 500 is valued on the basis of the market capitalization model. Meaning, the underlying companies having higher market capitalization have a greater impact on the S&P 500 compared to the companies having smaller market capitalization. 

S&P 500 consists of companies from a variety of industries and sectors. It chooses its underlying stocks mainly on the basis of liquidity and market capitalization. 

  1. Dow Jones Industrial Average

Dow Jones Industrial Average is one of the oldest and widely used stock market indexes of all time. Dow Jones Industrial Average was first introduced in the year of 1896 and is currently among the top 5 stock market indexes in the world. 

Dow Jones Industrial Average
Dow Jones Industrial Average

Dow Jones Industrial Average is made up of 30 large-cap U.S. companies. Dow Jones Industrial Average is valued based on a price-weighted model. Meaning, the underlying stocks having a higher price per share impacts the index more than the stocks having lower price per share. This index consists of companies from multiple industries and sectors. Hence, it is often looked upon as the barometer of the overall U.S. stock market. 

  1. NASDAQ Composite

NASDAQ (National Association of Securities Dealers Automated Quotations) Composite was first introduced in the year of 1971. NASDAQ composite tracks the performance of the companies that are listed on the NASDAQ stock exchange and is one of the top 5 stock market indexes in the world. 

Nasdaq Composite
Nasdaq Composite

NASDAQ composite tracks more than 3500 stocks and primarily focuses on the technological and growth-oriented industry. NASDAQ Composite is valued based on the market capitalization model. Meaning, the underlying stocks having a higher market capitalization affects the index more than the stocks having lower market capitalization. It is often looked upon as the benchmark index for technology-related stocks. 

  1. Russell 1000

Russell 1000 was first introduced in the year of 1984 and currently among the top 5 stock market indexes in the world. Russell 1000 tracks the performance of the top 1000 large-cap companies based in the U.S.

Russell 1000
Russell 1000

Russell 1000 index is a market capitalization-weighted index. Meaning the underlying companies having a higher market capitalization affects the index more than the companies having lower market capitalization.

The companies under Russell 1000 are chosen from the Russell 3000. It focuses on a wide variety of industries and sectors. This is why, Russell 1000 is considered as the benchmark for tracking the performance of the top 1000 U.S. large cap stocks. 

  1. S&P 100

S&P 100 was introduced in the year of 1983 as a sub-part of the S&P 500. S&P 100 consists of top 100 traded stocks in the U.S. It is often looked at as the benchmark of large-cap U.S. stocks and is one of the top 5 stock market indexes in the world. 

S&P 100
S&P 100

S&P 100 is a market-capitalization weighted index. Meaning, the underlying stocks that have a higher market cap affects the index more than the stocks having a lower market cap . S&P 100 is made up of stocks from a variety of industries and sectors. 

Investing in these top stock market indexes help get the best exposure to the growth of equity markets. But ensure you consider the risk that comes with as well for best results. 

What are the popular Stock Market Indexes in India?

The most popular stock market indexes in India are the ones that generally attract the most amount of volumes. Following are 3 of the most popular stock market indexes in India.

  1. S&P BSE Sensex

S&P BSE Sensex, usually called Sensex, was introduced in the year of 1986 and since then, it has become one of the most popular stock market indexes in India. S&P BSE Sensex tracks the performance of the top 30 companies listed on the Bombay Stock Exchange (BSE).

S&P BSE Sensex
S&P BSE Sensex

S&P BSE Sensex is a market capitalization-weighted index. Meaning, the underlying stocks that have a higher market capitalization affects the index more than the stocks having lower market-cap. S&P BSE Sensex is made up of companies that represent a wide variety of industries and sectors. Therefore, Sensex is looked upon as the benchmark of the Indian economy. 

  1. CNX NIFTY (NIFTY 50)

CNX Nifty, also known as Nifty 50, was introduced in 1996 and since then, Nifty 50 has become one of the most popular and followed stock market index in India. Nifty 50 tracks the performance of the top 50 companies listed on the National stock exchange (NSE).

CNX NIFTY (NIFTY 50)
CNX NIFTY (NIFTY 50)

The underlying stocks of Nifty 50 are selected on the basis of their trading volume and liquidity. Nifty 50 is a market capitalization-weighted index. Meaning, the underlying stocks that have a higher market capitalization affects the index more than the stocks having lower market-cap. It comprises stocks from a wide variety of industries and sectors. And therefore, It is known as the benchmark of the Indian stock market. 

  1. BSE Bankex

BSE Bankex index was first introduced in 2003 and since then, it has become one of the most popular stock market indexes in India. BSE Bankex tracks the performance of the most liquid banking stocks listed on the Bombay Stock Exchange (BSE). 

BSE Bankex
BSE Bankex

BSE Bankex is a market capitalization-weighted index. Meaning, the underlying stocks that have a higher market capitalization affects the index more than the stocks having lower market-cap. BSE Bankex focuses on both the private and public sector banks of India. It helps an investor in tracking the banking sector of the Indian economy. 

Investing in the above top three indexes are an excellent way to begin passive investing in India. Ensure you carefully consider your risk appetite and investment goals to get the best out of your investment. 

What is the importance of these Stock Market Indexes?

Stock market indexes are important because of their features. The importance of stock market indexes can be summarized in 3 points. 

  1. The Stock market index acts as a benchmark – 

The stock market index provides investors with a collective measure by tracking the performance of its underlying stocks. This helps investors in comparing the performance of their own portfolios compared to the broad market. Furthermore, stock market indexes track all types of market sectors and makes it easy for investors to track a specific sector of the overall stock market. 

  1. Stock market indexes help investors in investing – 

Rather than analyzing and choosing an individual stock, stock market index provides a hassle-free approach towards investing and enables investors to invest in broader markets. This diversifies an investor’s portfolio and therefore reduces the risk. 

  1. Stock market indexes help investors in analyzing the overall health of an economy – 

The stock market index helps investors and financial analysts in analyzing the overall health of a nation’s economy. It also offers insight about the multiple market segments and opens many opportunities for investors. 

Overall, the stock market indexes help financial analysts and investors by reducing both time and efforts required in the process of investing. 

How to read Stock Market Indexes?

Reading stock market indexes is very simple once you brush up your stock market basics. Reading the stock market index involves having the knowledge of what purpose does the index serve and what are the underlying stocks that are involved. Once you know all of this, telling whether an industry or the overall stock market is booming or busting just by seeing its index gets very easy. 

How to calculate Stock Market Indexes?

Calculating Stock market indexes can seem difficult but it is not actually. You can calculate the value of a stock market index in 5 steps. Let us take the example of a calculation of the S&P 500. 

Calculating stock market indexes, such as the S&P 500, is done in a few steps. To better understand the process, let’s expand on the given steps and use a hypothetical market cap-weighted index with five constituents as an example. The steps are as follows:

Step 1: Identify the constituents of the index

For the S&P 500, you would need to identify the top 500 companies that constitute the index. In our hypothetical example, we have five stocks: A, B, C, D, and E.

Step 2: Calculate the market capitalization of each stock

Multiply the stock price by its outstanding equity shares to find the market cap. For our example, we have the following market values.

STOCK NAMESTOCK PRICESHARES INCLUDEDMARKET VALUE
A$350$150
B$150$50
C$770$490
D$920$180
E$1010$100

Step 3: Calculate the weight of each stock in the index

Divide each stock’s market cap by the total market cap of all stocks in the index. In our example, the total market value is $970, and the weight of each stock is as follows.

STOCK NAMEINDEX WEIGHT
A15%
B5%
C51%
D19%
E10%

Step 4: Calculate the index value

First, choose a base value for the index. In our example, we’ll use 100. Next, calculate the index divisor by dividing the total market value by the base value (e.g., $970 / 100 = 9.7). Multiply each stock’s weight by its price, then sum up these values for all stocks in the index. Finally, divide this total by the divisor to obtain the index value.

Step 5: Update the index value over time

As stock prices change, the index value will also change. To calculate the new index value, update the market values and weights of the stocks, then follow Step 4. The divisor remains constant unless the index constituents change, such as in the case of a stock delisting or a stock split.

Index values are used to calculate the performance of the index between two dates. To do this, divide the ending index value by the beginning index value, subtract 1, and multiply by 100 to obtain the percentage change.

It is important to note that index values vary widely depending on the index and index provider. Comparing index values directly may not be meaningful, as they have different base values and starting points. Instead, focus on comparing the performance or growth of index values over time.

How to invest in Stock Market Indexes Funds?

Investing in stock market index funds is pretty easy. Investing in stock market index can be done by following these 3 simple steps. 

  1. Identify your investment goals – 

Before making any investment-related decisions, you must be very clear about your investment goals. This helps you in deciding the investment tenure and the risk you are willing to take for achieving your financial goals.

  1. Open Demat and Trading account – 

You should always open a Demat and a trading account with a renowned and trustable broker. There are multiple well-known and trusted discount brokers online. Choose one and deploy the funds you wish to invest. 

  1. Choose the fund you want to invest in –

After deciding your goals, it is time for you to decide the index fund which you think will help you in achieving your financial goals in a much more effective way. For example, if you think that the Indian economy will do great in the future, then consider investing in an index fund which tracks the Indian benchmark index of Nifty 50. 

Following the below steps will help you invest but ensure you thoroughly monitor you investments every now and then to ensure it aligns with your goal.

What is Exchange Traded Fund or ETF?

An Exchange Traded Fund (ETF) is an investment instrument which consists of a portfolio of stocks, bonds, commodities or all of these bundled together to represent a specific investment methodology. An ETF usually mirrors the performance of a specific market index or a market segment. 

An ETF is traded on the stock exchange just like stocks. Let’s take an example of an ETF. Suppose you want to invest in an investment product which mirrors the performance of the Nifty 50 index. This can be easily done by buying an ETF called “Nippon India ETF Nifty BeEs”.

Nippon India ETF Nifty BeEs mirrors the performance of the Nifty 50 index. Meaning,  investing in this index fund will give you the same returns as the Nifty 50 index. 

Is ETF the same as Market Index?

No, an ETF is not the same as the market index. Both ETFs and stock market indexes are different instruments that are used for different purposes. A stock market index is a statistical measure of its underlying stocks. Investors use the stock market index to track the performance of the whole stock market or a specific stock market’s segment.

On the other hand, an ETF is an investment tool which is made up of a portfolio of stocks, bonds or commodities. Unlike stock market indexes, ETFs are used as an investment product to invest in broader market sectors for diversification.

Do exchange traded fund matter in the Stock Market?

Yes, Exchange Traded Fund (ETF) matters in the stock market. Exchange-traded funds matter because ETFs help in increasing the overall liquidity of the stock market because of its functions. ETFs also provide a great way for diversification of an investor’s portfolio.

Furthermore, the cost of buying and selling an ETF which tracks the performance of an index is less compared to the cost of buying and selling an index fund through mutual funds. 

What is weighted indexes?

A weighted index is a type of index where the underlying stocks are assigned a specific weightage based on certain criteria. Weighted indexes weigh the underlying stocks based on factors like stock’s price per share, market capitalization or revenue of the company. Here are some of the common weighting index models – 

  • Market capitalization weighting model
  • Price weighting model
  • Equal weighting model

What is the difference between weighted indexes and Stock Market Index?

The difference between a weighted index and a stock market index is very subtle. The main difference between a weighted index and a stock market index is that the stock market index is a broader term which is used to describe a collective measure of its underlying stocks.

A stock market index is used to track the stock market as a whole or a specific market segment. Whereas, weighted index is a subsidiary term of the stock market index. Weighted indexes are the index that assign value to its underlying stocks on the basis of some criteria. 

 

Arjun
Arjun Remesh

Head of Content

Arjun is a seasoned stock market content expert with over 7 years of experience in stock market, technical & fundamental analysis. Since 2020, he has been a key contributor to Strike platform. Arjun is an active stock market investor with his in-depth stock market analysis knowledge. Arjun is also an certified stock market researcher from Indiacharts, mentored by Rohit Srivastava.

Shivam
Shivam Gaba

Reviewer of Content

Shivam is a stock market content expert with CFTe certification. He is been trading from last 8 years in indian stock market. He has a vast knowledge in technical analysis, financial market education, product management, risk assessment, derivatives trading & market Research. He won Zerodha 60-Day Challenge thrice in a row. He is being mentored by Rohit Srivastava, Indiacharts.

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