If you are a beginner in the stock market, you might have heard of Nifty 50 and Sensex, which are two popular indices based on the Indian markets.
But what exactly is an index in the stock market, and how does it work? In this blog, we will provide a simple and easy-to-understand explanation of what an index is in the stock market and how it works. So let's take a deep dive into it.
What is an Index in the Stock Market ?
An index is an imaginary basket of stocks representing the Indian stock market. This basket includes different sectors, including Financials, IT, Pharma, Auto, etc.
This index acts as a tool to measure the price variations in the basket.
This basket standardises the price movements, making it comparable to compute returns and act as a benchmark while calculating the performance of any stock in the Indian Stock Market.
An index becomes a sample size to understand the price changes in the underlying Indian stock market. It tries to give a general trend for the stocks in the market, whether they are going up or down.
Nifty 50 contains the 50 largest companies (in terms of market cap, which is basically share price multiplied the number of shares of a company) listed in the Indian stock market, which are from different sectors of the Indian economy
Similarly, Sensex is a basket of 30 of the largest companies listed in the stock market. This index is not a sure short way to tell if any specific stocks or your own basket of stocks called your portfolio is going to be up or down today. It may be the case that your portfolio may go down and the index may go up as it depends on how much “weight” each stock has in the index, which will be explained later on
Stocks present in these indices can even shuffle based on their performance. If Stock A, which is a part of the Nifty 50, is not able to perform well and its market cap becomes lower than Stock B’s market cap, then in the index of the Nifty 50, Stock A will be replaced by Stock B.
This change in constituents always ensures that the best performing stocks are represented by the Nifty 50 index. Since only the best performing stocks are in the Nifty 50, less learned investors can buy this basket of the Nifty 50 and keep it as an investment as opposed to creating their own basket, which might not do as well as the index.
Now that we have a basic understanding of what an index is, let’s revisit something we mentioned earlier - weightage.
Index Weightage
In the index, not all the top 50 stocks of the market have an equal weightage. Their weightage depends on their free float market cap (how much of the company is available for retail investors to buy) and sector that it belongs to, but let’s focus on the former.
Free Float Market Cap = Share Price * No of Shares Available To Invest
The stocks in the Nifty 50 are based on their market capital relative to the market cap of the Indian stock market.
Lets assume that the Market Cap of Reliance is Rs. 100 crore and the Market Cap of the whole of stock market is Rs. 1,000 crore. Then, Reliance stock will be given a 10% (Rs. 100 crore/Rs. 1,000 crore) weight in Nifty 50!
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