What Are Stock Market Indexes? Meaning, Types & Methodology

The stock market is a dynamic environment where shares of multiple companies are traded regularly. Stock prices fluctuate on a daily basis fueled by various factors ranging from simple demand and supply mechanics to complex economic news and corporate earnings. Stock market indices were conceptualised to help traders and investors quickly and easily measure the performance of the stock market and its various segments. These indices provide a snapshot of market trends and allow traders and investors to make effective decisions.

Key takeaways

• A stock market index provides a snapshot of the performance of the overall market or a specific segment.
• It is also used as a benchmark to measure the performance of investment vehicles and portfolios.
• Stock market indices can be categorised into different types based on their composition and purpose.

What is a stock market index?

A stock market index represents the combined value of a select group of stocks. Depending on the type of index, it can either represent the market as a whole or a specific market segment. The movement of a stock market index is directly linked to the movement of the stocks contained within it. For instance, if the prices of stocks in an index fall, the value of the index will also go down and vice versa.

Traders and investors widely use stock market indices to track the performance of the overall market or a market segment. They may also use it to compare the performance of individual stocks or investment portfolios relative to that of the market.
 

Categorisation of stock market indices

Market indices can be classified into different categories based on their composition and objectives. Here is a quick overview of some of the most common types of stock market indices.

1. Broad market indices

Broad market indices are designed to represent the performance of the overall market. These indices usually feature stocks from various sectors and market capitalisations and are widely used as benchmarks to measure investment performance. Nifty 50 is the most widely used broad market index in India. Other popular indices include the BSE Sensex, Nifty 500 and BSE 500.

2. Market capitalisation indices

As the name implies, market capitalisation indices are designed to represent the performance of stocks belonging to a particular market cap segment. These indices are sub-categorised into four different types: large-cap, mid-cap, small-cap and all-cap.  

3. Sectoral indices

Sectoral indices are designed to represent the performance of the stocks operating within a specific sector or industry. Some examples of sectoral indices include Nifty Bank, BSE Auto, Nifty Oil & Gas and BSE Financial Services.

4. Thematic indices

Thematic indices are designed to represent stocks related to certain specific investment themes or trends. These indices often consist of companies across various sectors and market capitalisations united by a common theme. BSE India Manufacturing Index, Nifty Infrastructure, and Nifty100 ESG are some of the examples of thematic indices.

5. Other indices

In addition to the types of stock market indices mentioned above, there are other categories such as investment strategy indices, fixed-income indices, hybrid indices and volatility indices.
 

As an investor, you must understand how a stock market index is formed. Here is a generic overview of the index formation methodology that is widely followed in India.

1. Selection criteria

The first step involves establishing the rules or eligibility criteria for the inclusion of stocks in an index. The criteria for stock selection vary depending on the stock market index and its objective.

2. Weighting method

Once the list of constituent stocks is prepared, each of them is assigned a particular weightage. The weightage assigned to a stock determines the impact it has on the index value. Stocks with high weightage often tend to strongly move the index compared to stocks with low weightage.

Most types of stock market indices in India follow the free-float market capitalisation method for assigning weightage to their constituent stocks. In this method, companies with larger free-float market capitalisations are assigned higher weights.

Some indices follow the price weighting method, where higher-priced stocks are assigned higher weights. This method, however, is widely used by U.S. stock market indices.

3. Value calculation

The index value is calculated by using a mathematical formula, which involves dividing the sum of the free-float market capitalisation of all of the index’s constituent stocks by the base market capitalisation value. The resulting figure is then multiplied by the base index value to arrive at the present index value. Most major indices are calculated and updated in real-time during market hours.

Conclusion

A stock market index plays a crucial role in the Indian financial markets. It provides investors, analysts, and policymakers with valuable insights into market performance and trends. As the investment landscape in India continues to evolve, many new types of stock market indices are expected to be introduced. However, irrespective of how many indices are introduced, the index formulation methodology is likely to remain the same.