I am sure you have often heard of the word Nifty and Sensex being referred to frequently by business channels and analysts. But do you really know what these names truly mean? Well, that is what we are going to talk about in this blog post.
But before we get into understanding what Nifty and Sensex are, we need to understand the basics about stock exchanges and index (or indices) as both Nifty and Sensex are indices that represent stocks listed on these stock exchanges.
There are two major exchanges in Indian stock market, the BSE or the Bombay Stock exchange, and the NSE, or the National Stock exchange. Think of these exchanges as two different shopping malls where stocks are like different shops. Both of these exchanges have thousands of stocks listed with them. Investors can choose to trade and invest in any of these stocks exchanges.
Just like any shopping mall, both these exchanges need to keep track of the business being done by measuring how well these exchanges and the entire market is performing. But there was a problem.
There are thousands of companies listed in each of these stock exchanges, keeping track of all of their daily activity is really a monumental task. Thus, there is a need to create a simple way to keep track of market performance.
The solution was to take a sample of top stocks of exchange and combine them in such a way that it best represents the performance of the financial market. These combined samples of stocks are known as an index.
What is an index?
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The definition of an index is as follows:
“An index is a statistical aggregate that measures change”
Source: Investopedia.com
Put simply, an index is a combination of selected stocks that helps measure the performance and the value of the stock market. The index is computed by taking a weighted average of top stocks by market capitalization.
Every exchange has its own index, BSE has Sensex and NSE has Nifty.
What is Sensex?
So what is Sensex? Well, Sensex is also known as BSE 30 index and is used by BSE to measure the financial performance of the top 30 companies listed in the BSE. These 30 companies are chosen on the basis of their market capitalization, representing different industries and sectors.
The top 10 companies that compose the Sensex are as follows:
As I mentioned earlier, every index whether it is Sensex or Nifty, is a weighted index, meaning different companies hold different weightage in the index. The movement of Sensex whether it is up or down is determined by the movement of the stocks that compose the Sensex.
Companies with most weightage have the highest influence on the movement of the index.
For instance, HDFC Bank has the highest weightage in the index, so if the HDFC bank moves up or down, it will move the Sensex by the same proportion. For example, if the HDFC bank moves 100 points up, it will move the Sensex by 11.5 points (assuming all the other stocks do not move at all). Similarly, if the HDFC bank moves 100 points down the Sensex will move 11.5 points down.
What is Nifty?
Just like Sensex, which is an index for BSE, Nifty, also known as Nifty50 is an index for NSE, is composed of the weighted average of the top 50 companies listed on the NSE, and is used to measure the financial performance of the NSE.
Similar to BSE, these 50 companies are chosen on the basis of their market capitalization, representing different industries and sectors.
The top 10 companies that compose Nifty as per their weightage on the index are as follows:
As you can see from the screenshot above, the companies with the highest weightage in the Index are HDFC Bank, Reliance Industries, HDFC, ICICI Bank and so on, the upward and downward movement of the Nifty is largely determined by the movement of these companies. Companies with the highest weightage have the largest impact on the movement of the index.
For example, HDFC Bank has the highest weightage on Nifty of 10.73%, so if HDFC Bank moves up by 100 points, the Nifty will move up by 10.73 points (assuming that other stocks do not move at all)
Importance of Index:
Having explained almost everything about indices, there is one question that remains unanswered. Why do we need an index like Sensex and Nifty? What is its importance? There are many reasons why an index is important and why we need it. Some of the reasons are explained below:
It’s a barometer to the market:
If you want to measure anything, you need a scale, a measuring unit to check its progress. If you want to measure your body temperature, you need a thermometer, if you want to measure the economic growth of a country, you use GDP as a metric.
Similarly, if you want to measure the performance of the stock market, you need a metric to measure it, which is provided by index.
An index helps you understand if the market is progressing upwards or is going through tough times.
It acts as a benchmark:
An index can also act as a benchmark for measuring the performance of individual stock portfolios.
Since an index is composed of the biggest companies in the stock market, it is the best benchmark to measure your portfolio’s performance. If your portfolio is consistently giving higher returns compared to the index, it means that your portfolio is outperforming the biggest companies in the country.
Reflects the investor sentiment:
An index is also a great indicator of investors’ collective sentiments. In other words, the movement of an index over a period of time reflects peoples’ collective sentiment and opinion about the future of the markets.
When the top indices like Nifty and Sensex rise continuously, it shows that the people are optimistic about the future of the market, and thus want to invest in it expecting to get higher returns in the future. Similarly, when indices like Nifty and Sensex keep declining for a long period of time, it reflects that people are not very optimistic about the market and thus refrain from staying invested in it.
Passive Fund management:
There are many investors who do not have much knowledge about investing in the stock market. Such investors do not have a huge risk appetite and do not want to go through the painful process of picking individual stocks to construct their portfolio. In such cases, a passively managed index fund can be a huge blessing.
Since an index is a readymade portfolio of stocks, it can act as a great way to create a passive fund. An index fund simply copies the components of an index instead of carefully pickling each individual stock.
An index is simply a great way to passively manage your investment portfolio as an index rarely goes through massive changes in the allocation of stocks and even if it does, an index fund automatically aligns itself as per the changes in the underlying index.
Conclusion:
Before I wrap up this blog post, there are few important points that I would like to share with you about Nifty, Sensex and other indices in general which as investors, must keep in mind while investing in the stock market.
First, it is true that indices like Nifty and Sensex are the barometers of the Indian stock market, however, many investors confuse the movement of these indices as an accurate representation of the entire stock market’s sentiment.
There are more than 5,000 companies listed in NSE alone, an index composed of just top 50 of them cannot accurately represent the sentiment of the entire market.
So if you find Nifty or Sensex going up and down, it does not mean that that the entire kitty of 5,00 plus stocks will meet the same fate.
There are always pockets of stocks and sectors that perform well despite the poor show by these indices.
I hope you find this post in what is Nifty and Sensex useful and knowledgeable, if you have any question regarding this, please feel free to comment below:
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