Indexes of the financial market can be described as a collection of chosen shares that are handpicked on the basis of certain features like the frequency of trades, market capitalisation, share size, etc. Top stock market indices in India include the Nifty 50 and Sensex. Indexes are important indicators in a financial market. If you are wondering what a stock market index is, do not worry; this article is perfect for you. We will discuss the stock market index’s meaning, its different types, and the index formation process.

• A stock market index is a statistical tool used to measure market performance and track the price movements of a specific group of shares or industries.
• Indices are categorised by sector (e.g., NSE Pharma), market capitalisation (e.g., S&P BSE SmallCap), or used as benchmarks (e.g., Nifty 50).
• Stocks on an index can be weighted based on their market capitalisation or their price, which affects the overall index value.
• In India, free-float market capitalisation is often used, which considers only publicly traded shares when calculating a company's market cap.

Let us begin by understanding the meaning of a stock market index. Simply put, it is a statistical source which is used as a measure of fluctuations in the market. You can think of an index as a performance indicator which can be attuned to measure the performance of a specific industry or group of shares, or the entire equity market.

An index is typically made by picking stocks from businesses which are similar based on predetermined criteria. The only prerequisite is that the companies must be publicly listed on the stock exchange. Every index is created to track the performance and prices of its constituent stocks. If the prices of its stocks increase, so does the index.

Now, let us discuss a few salient types of stock market indices. These are:

Sectoral index

In India, the top stock exchanges have their own indices which are geared towards measuring the performance of specific industries. For instance, NSE Pharma and Nifty PSU Bank are prominent sectoral indices.

Benchmark index

Examples of benchmark indices in India include the Nifty50 or the Sensex. These indices are benchmarks as they list only the top 50 and 30 companies, respectively, and regulate the index to choose only the biggest industry leaders. These indices are popular and trusted among investors to gain insights into the market.

Market capitalisation index

Certain indices are created with companies chosen based on their market capitalisation. A prominent example is the S&P BSE SmallCap, which is composed of small-cap companies.

Other indices

Besides the above, several indices like the NSE 100, S&P BSE 500, and S&P BSE 100 are comparatively broader and have more listed stocks.

The process of creating a stock market index entails clubbing together stocks which have similar business sizes, are from the same industry, or have similar market caps. Then, calculations are done based on the lot size. The stocks retain their distinct prices but they differ in their price ranges. Thus, the value of the index is not a simple summation of the constituent stocks.

This is where assigning a certain weight to the stocks gains prominence. Every share on the index is weighted as per its market capitalisation or market price. This has a direct influence on the overall index price fluctuation.

The two most popular weightage methods are:

Market cap weightage

The market cap of a company is computed by multiplying the stock price of a company by its total outstanding stocks issued. Indices which are market-cap-weighted, choose stocks by taking into consideration their market caps in relation to the broader index market cap.

It is important to note here that a company's market cap is hugely variable and fluctuates daily. This results in the weightage of the stocks on an index to also fluctuate. In India, the concept of free-float market capitalisation is also popular among indices, where the market cap is calculated based on the total amount of publicly traded shares instead of the total outstanding shares, which may include non-publicly traded shares like those held by promoters or insiders.

Price weightage

In this method, the value of the index is computed based on the stock prices of the businesses and not the market capitalisation. This means that the weightage of a stock on the index would depend on its price, and a higher-priced share would have more weight than lower-priced shares.

Stock market indexes serve as crucial benchmarks for tracking the overall health of the financial markets and the performance of specific sectors or groups of stocks. By understanding different types of indices, such as sectoral, benchmark, and market capitalisation indices, investors can make informed decisions about market trends and opportunities. Whether you're a seasoned investor or a beginner, grasping how stock indices function is key to navigating the stock market successfully.