Understanding Indices

This is the first
question that any investor asks of his peers or even his broker. Why
should an individual investor, even if he does not own a single stock
in a broad market index like the Sensex, be bothered so much by one
indicator? This line of thinking is not only evident at an individual
level but to brokers, traders, the media and institutional investors.
Though people may believe that index levels do not affect stock
picking, rarely will you find them ignoring indices altogether. The
index is not just a popular number but a snapshot of market behaviour.
Hence, it is tracked globally to gauge market moods. The BSE Sensex or
the Nifty serves as a proxy for the market as they represent a
diversified portfolio of stocks.

Indices have uses other than
just providing a market direction; they can be used to hedge one’s
portfolio, speculate on indices themselves using futures or as index
funds do, track them to spread investment risk.

Risk
optimisation is the primary objective of any investor, to maintain
returns and lower risk. Since an index represents a diversified
portfolio of stocks, it cancels out fluctuations attributable to
individual stocks. Stock price movements are dictated by two factors.
One is a company specific event like a closure, strike, accident,
bumper results which is referred to as non-systemic risk. The other is
external events like a flood, war or a global recession which is called
non-systemic risk.

By diversifying, you seek to reduce the
non-systemic risk by spreading your investments across companies.
Hence, an ideal index is expected to reflect only systemic risk, which
cannot be reduced.

An index has
practical applications in the world of finance. Derivatives and index
funds both make extensive use of indices. Both the NSE and BSE have
launched index futures based on the S&P CNX Nifty and BSE Sensex
respectively. The global market for index services and their
applications is a multi-trillion dollar industry.

Indices also
serve as a benchmark for measuring the performance of fund managers and
their respective funds. For gauging the performance of individual
sectors or sectoral mutual funds, sector specific indices can be used.

Theoretically,
index fluctuations reflect changing expectations of the stock market
about future stock returns. An upward movement in the market index on a
particular day implies that the stock markets expect higher future
returns from the stocks as compared to the expectations on previous day
and vice versa. However, since indices are derived from the market
capitalisation of stocks, it is quite possible that a few stocks
account for a major portion of the index. Thus, fluctuation in prices
of a few stocks may affect the overall index too which will give an
incomplete picture.

Hence, it is advisable to follow a
broad-based index that is an index constructed using a large number of
stocks spread across a wide range of sectors to gauge overall
performance. Also, an index should not consist of illiquid stocks in
its portfolio since in such cases, the index can be easily manipulated
by manipulating the prices of such illiquid stocks. Construction of an
Index Most market indices are constructed using the value-weighted
method. In this method, the initial market value of these stocks is
assigned a base index value. Say, we take the base year as 1982 and
take 30 stocks which have a total market capitalisation of Rs 3,000
crore. Let us assume that the base value on the first day is 100.

Suppose
the market capitalisation on the next day of these 30 stocks increases
to Rs 3,300 crore. To calculate the index, you take that day’s market
capitalisation, divide it by the base figure and multiply by 100 to get
the new index. In this case it will be, 3300/3000 multiplied by 100 to
get 110 points. Care should be taken to distribute the stocks selected
across a wide number of sectors so that the index is not skewed towards
a particular sector. An index which, is constructed using stocks
belonging to a sector results in a sectoral index. For example, an
index comprising all software stocks will represent the software
sector. Such indices are useful for gauging the performance of
individual sectors and sector specific mutual funds.

Foreign
institutional investors are a huge force in the Indian equity markets
even compared to domestic mutual funds. As a result, international
equity market developments often have a bearing on Indian stock
markets. That’s why early in the morning, investors take a look at what
happened in the US markets. The two indices that are widely tracked are
the Nasdaq Composite Index and the Dow Jones Industrial Average.
Nowadays, as India forms part of the Emerging Markets, movements in
markets like China, Taiwan and Japan too have an impact on local market
movements