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Ask Mint | The ingredients that go into making a stock market index

Ask Mint | The ingredients that go into making a stock market index
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First Published: Sun, Jun 15 2008. 10 18 PM IST

Updated: Sun, Jun 15 2008. 10 18 PM IST
The stock market has its own band of messengers in the guise of indices: the Sensex, Nifty, Bankex and a host of others. They all try to convey the mood of the market and yet each one of them claims to be practising a different science.
But, the fate of all indices at the end is similar to that of a messenger. If the news is good, they receive the cheers, and if the news is bad, they receive the brickbats. Our friend Johnny has no idea that indices hardly have any control over the mood of the market. They simply narrate whatever happens in the market.
Johnny: All stock market news boils down to just one thing: How much has the market index gone up or down? But I have no idea what a stock market index is made of.
Jinny: Stock market indices such as the Sensex or Nifty are the first things that we hear about in any stock market news. Even people who have never invested in the stock market know about these terms. But many may not know what exactly a stock market index is. Well, a stock market index represents the composite value of shares of different companies traded on a particular stock exchange. Till the late 1980s, our stock market had no index.
The Bombay Stock Exchange (BSE) came out with the first stock index, popularly known as the Sensex, in 1986. Later, in the 1990s, the National Stock Exchange (NSE) came out with another stock index, which came to be known as the Nifty.
At present, both the stock exchanges have many more indices, each one of which tries to catch the mood of the market differently. The Sensex represents the composite value of shares of 30 selected companies traded on BSE. The Nifty represents the composite value of shares of 50 companies traded on NSE.
All stock market indices essentially perform the same function—they provide us a common measurement of the rise and fall of the prices of shares included in theindex. Since the shares of most companies are traded on both BSE and NSE, the indices of both exchanges may include the same companies. However, this may not be always true.
So, whenever you have some spare time, go to the websites of these two exchanges and try to spot the differences in composition of these two indices.
Johnny: Well, Jinny, if I start comparing these two indices side by side, I may get confused. So, for the sake of simplicity, let’s just keep our focus on the Sensex, the oldest index. Tell me, how is an index formed?
Jinny: Before making any index, you have to choose three basic ingredients. First, choose a base year which serves as the starting point of all our calculations. The Sensex uses 1978-79 as its base year. Then choose the number of companies to be included in the index. The Sensex includes the shares of 30 companies.
Finally, you have to choose the base value. The Sensex uses 100 as the base value. Once we have these three basic ingredients, then and only then can we think of making an index.
Johnny: I was wondering why the Sensex includes the stocks of only 30 companies and why it uses 100 as the base value.
Jinny: There is no written rule which says that only 30 companies should be included in an index. So, the Sensex could have very well included 50 companies or 100 companies, but at the time the Sensex was formed, many popular indices of other countries used 30 stocks.
Likewise, there is no compulsion to use 100 as the base value. The Sensex could have very well used 10 or 1,000 as its base value. But 100, I think, looks good as a starting point of index calculation. It is neither too large nor too small. The base value helps us in keeping the scorecard of company shares. It serves as the starting point of all calculations. So, when the Sensex first started counting the ups and downs of the stock market, it started from the value of 100.
Johnny: But on what basis were these 30 companies chosen?
Jinny: Well, the composition of the 30 companies in the Sensex keeps changing periodically. Many factors are considered while deciding which company is to be included. The size of the free float market capitalization, frequency of trading, listed history and track record, and industry representation are some factors on the basis of which the selection is made.
Earlier, when the Sensex was formed, it used the weight of market capitalization of companies, but subsequently, from September 2003 onwards, it shifted to the free float market capitalization method. The whole process involved redoing the entire calculation from the base period.
Johnny: Wait a minute! You are confusing me. What’s the difference between market capitalization and free float market capitalization?
Jinny: I will tell you more about that next week. Till then, I think you should get ready—improve your mathematical skills by doing some mental exercise.
Index basics
What: Stock market indices such as the Sensex and the Nifty measure the composite value of stocks included in the index.
Why: Indices perform a useful role by providing a common measurement tool for the rise and fall of stock prices.
How: The Sensex uses the free float market capitalization of 30 companies for calculating the value of the index.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at realsimple@livemint.com
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First Published: Sun, Jun 15 2008. 10 18 PM IST
More Topics: Stock Index | Nifty | Sensex | Money Matters | Equities |