What is an Index?

Whenever we open any business channel, we see a bar at the bottom which shows the current market price (last traded price) of stock and typically on the bottom right corner, there is a number which shows the current value of an index. Like in the snapshot from Fox business, it is showing Dow Jones Industrial Average (Dow Jones or simply Dow) currently priced at 26503.77. In this snapshot, there are three indices shown at four different places which lead us to ask questions such as what is an index? What is its significance? Why is it so important? 

Fox Business Channel snapshot

An index is an indicator or a measure of something. In the world of investing, it is a hypothetical portfolio of stocks and bonds designed to represent the market. When people say the market is moving up and down, they are referencing the movement of the index. Some of the most popular stock market indexes are: 

• Dow Jones Industrial Average (US) 
• S&P 500 (US)
• NASDAQ (National Association of Securities Dealers Automated Quotations - US) 
• Nikkei 225 Index (Japan) 
• DAX 30 (Germany) 
• FTSE 100 (United Kingdom) 
• Hang Seng Index (Hong Kong). 

In India, there are two benchmark indexes: Sensex and Nifty 50.  

There are two types of indexes based on how it is computed – weights are assigned to each stock either on the basis of price or market capitalisation. Dow Jones and Nikkei 225 are assigned weightage on the basis of the price of the stock while Sensex and Nifty are assigned on the basis of market capitalisation. 

Sensex is calculated using the free-float market capitalisation method (shared that are pledged or locked-in are not considered). Being a sensitive index (Sensex), it consists of 30 largest and most traded companies across various sectors of the Indian economy. Weights are assigned in favour of the size of the company i.e. the bigger (market capitalisation wise) the company, higher will be the weight assigned to it. The base value of Sensex is taken as 100 on April 1, 1979. Suppose, if you would have bought all the shares of Sensex as per the weight for ₹10,000 on April 1, 1979, and on the next day if the price would have increased by ₹500 (5%) then the value of Sensex would also have increased by the same 5% i.e. 105. 

Nifty 50 (or Nifty) as the name suggests consists of top 50 most actively traded stocks across 24 sectors. Nifty is calculated using the same methodology as of Sensex. The base year for Nifty is 1995 and the value of Nifty was set as 1000. 

Sensex and Nifty are the barometer of the Indian economy. It gives a quick measure of the state of the Indian economy. Many economists use the stock market index to get the glance of the economy of a country. It also reflects the investor sentiment, which will also help us in understanding investor’s behaviour. Indexes also help in passive investments, which we will discuss more in the next post. Passive investments are those investments where investors do not need to devote much time to research on where to invest.