Index funds are great tools for investments with minimal cost and safe returns and are designed to meet the overall performance of the market. An index fund is an investment that tracks the index of the share market or can say that it invests in all the stocks forming groups in the index at the stock exchange. But while searching for funds, you must have wondered about what is this index first of all. So you and I as an investor should first understand the concept of the stock market index and its importance.
What is a stock market index?
A stock market index is a way to measure the performance of the stock market and it shows the changes in the prices of stock. It will help the investors to compare the prices of stocks with their past movements. It is like a small and separate group in the stock exchange made up of some companies which are already listed on the stock exchange.
The companies so chosen are leaders among their peers in the particular sector of the stock market to which they belong. The Characteristics to choose the company to be part of it may be the market cap, market share, or size of the company. And the company which proves the leader in the benchmark will be included.
Since the market is volatile and it is not expected that any company will remain a leader forever, the combination of companies in the index also keeps on changing. Companies can be excluded from the group if it does not match the benchmark anymore and a new company can be included. So, the main focus is to have those companies in the indices only which are true leaders in their sector. And by this way, we can assume that the index shows the real stock market sentiment and indicates whether the market is performing positively or negatively.
Importance of an index in the Stock Market
An index is very important for every investor looking for an investment in the stock market. It is like a scale or indicator which keeps on telling the movement of the market whether it is negative or positive. In nutshell, the Indices of the market show the overall condition of the stock market. Through this, an investor can plan the stocks for his investment although the scope of correction and volatility needs to be taken care of.
How an index is made
As we already discussed the index is a sub-group in the stock market which is formed by the companies that are leaders in their respective sectors of operations. Each company carries some weightage according to the benchmark and its performance w.r.t that benchmark. Suppose an index is based on market cap and its total market cap is 10000 crores. Now, if the index has a company that has a market cap of 4000 crores then in this case the company will have 40% weightage among other companies.
Types of Index in the Indian Stock market
Before knowing the index of the Indian stock market, you must know what the stock exchange is and how it works. Since India has two popular stock exchanges namely NSE & BSE but also has some small exchanges which are not so popular because of negligible trades on them. NSE (National Stock Exchange) is the largest among them having the maximum daily turnover in terms of equity shares. Exchange provides services like trading, listing, data feeding, and settlement of shares. NSE has its own index which is a group of the top 50 companies out of all listed at NSE, and it is known as the Nifty-50.
BSE ( Bombay Stock Exchange) is the fastest stock exchange in the world with a speed of trade of 6 microseconds. BSE also provides the same services as NSE and it has its index of the top 30 companies called Sensex. It has CDSL as its depository participant to provide its services. Sensex is most widely tracked and it is traded at leading stock exchanges of BRICS nations.
Use of an Index for investors
A stock market index is a way to measure the performance of the stock market and it shows the overall sentiment of the market to its investors. So, it has some usage for an investor like:
Through the index, you as an investor can find out the overall behavior of the market for that time. By this, forecasting the stock movement can be accomplished but you must keep a margin for market correction always in mind. The index can help you find and select the best stocks among the pool by looking at the index and comparing the price movements of stocks with this group of companies.
It is actually the first step in stock selection, and you can choose the best among the basket of stocks only by comparing them with their peers. So, the index makes it easy for an investor to compare the stock with its competitors in the market and the sector of the stock market to which it belongs. As an investor, you can easily compare the stocks you are interested in and forecast the future of the stock.
Behavior of investors
There are many investors like you and me in the market who are regularly investing in the share market. The sentiments and behavior of the investors impact the overall price movement of the market heavily. Any rise or fall in the market or stock price is the result of any news because of which sentiments of investors changes and trade heavily. Hence by comparison of the stock market index with the stock price, we can get to know about the behavior of other investors for that particular stock. Accordingly, we can plan our investment strategy with respect to stock selection and the price at which to trade into.
How to invest in the Index of the stock market
As an investor, now you can easily invest in the index of the stock market through various means actively or in a passive way. The best way to invest is to invest with Index funds which are types of mutual funds categorically designed to invest in the indices of the stock market only. Index funds are a group of stocks that tracks the indices of the stock market and invest in the companies listed in the indices only.
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The last lines
The index acts as a benchmark and follows the overall performance of the stock market, so it can not generate higher returns than the returns of the stock market itself. So if you are expecting high returns, then investing in indices of the market is not a good option for you. However, if you are a risk avoider and planning for long-term investment tools, the index can be one of the best investment avenues to park your hard-earned money.