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WHY DO WE NEED INDICES?

Indices are an important part of the stock market. Here’s why we need stock indices:

Sorting:

In a stock market there are thousands of companies listed. How do you differentiate between all of those and pick one or two to buy? How do you sort them out? It is a classic case of a pin in a stack of hay. This is where indices come into the picture. Companies and their shares are classified into indices based on key characteristics like size of company, sector or industry they belong to, and so on.

Representation

Indices act as a representative of the entire market or a certain segment of the market. In India, the BSE Sensex and the NSE Nifty are considered the benchmark indices. They are considered to represent the overall market performance. Similarly, an index formed of IT stocks is supposed to represent all stocks of companies from the industry.

Comparison

An index makes it easy for an investor to compare performance. An index can be used as a benchmark to compare against. For example, in India the Sensex is often used as a benchmark. So, to find if a stock has outperformed the market, you simply compare the price trends of the index and the stock. On the other hand, an index can also be used to compare a set of stocks against a benchmark or another index. For example, on a given day, the benchmark index like Sensex may jump 200 points, but this rally may not extend to a certain segment of stocks like IT. Then, the fall in the value of index representing IT stocks could be used for comparison rather than each individual stocks. This also helps investors identify market trends easily.

Reflection

Investor sentiment is a very important aspect of stock market movements. This is because, if sentiment is positive, there will be demand for a stock. This will subsequently lead to a rise in prices. It is very difficult to gauge investor sentiment correctly. Indices help reflect investor’s mood – not just for the overall market, but even sector-wise and across company sizes. You can simply compare an index with a benchmark to see if has underperformed or outperformed. This will, in turn, reflect investor sentiment.

Passive investment

Many investors prefer to invest in a portfolio of securities that closely resembles an index. This is called passive investment. An index portfolio helps investors cut down cost of research and stock selection. They rely on the index for stock selection. As a result, portfolio returns will match that of the index. For example, if Sensex gave 8% returns in one month, an investor’s portfolio that resembles the Sensex is also likely to give the same amount of returns. Indices are also used to construct mutual funds and exchange-traded funds (ETFs).