The Stock Market Index – What it Indicates?

The Stock Market Index – What it Indicates?

Many people around the world still don’t know that What actually stock market indices indicate? And this is the reason they misinterpret the market every time. Here is a reader’s query.

Hi
thanks for response. i got your Blog through Google search. i have a small query
What the sensex or for that matter nifty indicates?
regards

Here is What is the Stock Market Index?

A stock market index is a method of measuring a section of the stock market. (Wikipedia)

So What does it means? Well, It means that from total number of listed companies in any countries, we select few Industry leaders from each and every Industry and make an Index of those companies. This is the gross estimate of calculating the over all general health of the stock market.

It’s like doing a Blood Sugar, ECG (Electrocardiogram), Cholesterol and Chest X-Ray and telling the patient that your over all general health is Good. But What if the Patient has Brain Cancer? The Doctor has not done CT-Scan to rule out anything wrong in the Brain and still he is telling you that You are Fit. The Stock Market Indices work on the same principle. They will just tell you the gross over all health of the stock market and nothing else.

Sensex is made up of 30 Large Cap Stocks in It. While Nifty is made up of 50 Large cap stocks in it.

Problem of Stock Market Index -

Well, The only problem of calculating the stock market health with this method is that, It is the statistical method so It only takes a small sample from the large number of companies listed on the stock exchange.

This method assumes that, Large Companies or Companies making large profits are good and thus considers themselves in the Index. Sensex is a Sample of 30 Companies while Nifty is a Sample of 50 Companies.

Now, What Happens with this method is that, whenever a Sensex is Up, people think that the over all condition of the stock market is good and when it is down, people think that condition of the stock market is good. Of course, Statistically speaking, Most of the time this is true. But Well, not the all the time.

Well, I am asking you that, What about the Companies which are not included in the Sensex and still posting a good growth and quarterly results? Will you invest in those companies when the Sensex is down or not?

Ideally, you should invest in those companies. But Most of the People won’t

Now, What about the Companies like Satyam? Satyam Computers was previously in the Sensex and Nifty as a Tech Giant. And people were blindly investing in them thinking that the fundamentals are good. This is because the stock indices only consider the large size of the Companies and nothing else.

I have checked all the reputed mutual fund schemes. None of them had ever invested in Satyam Computers in the past decade. ….Why?…Because the Fund Managers of those Companies knew since years that, There was some foul playing with the Financial Statements of the Company and they stay away from those Companies. (This is known as Forensic Accounting. But well, Here our discussion topic is different so let’s not discuss about Forensic Accounting here.)

Thus, the stock market Indices are the Media Hype. They are just to tell people the over all condition of the stock market and nothing else. Even if the stock indices are down, it doesn’t mean that there are no more companies remaining in the economy to invest.

Another problem with the Stock Market Indices is that, We Calculate these Indices with following method.

- Market-Value Weighed also known as Capitalization-Weighed Value.

This means the companies having larger market cap (Stock Market Price multiplied by total number of stocks). This means that, Companies having large market cap will have heavy influence on the Index. Thus, a small fraction of the price change will influence the Index.

Take the Example of Reliance Industries. The weightage of Reliance Industries in Sensex is 15-20%…. So it means that, every rupee change in the price of Reliance Industries stock will swing the Sensex by 6 Points….!!!!!

Now, That’s unbelievable…..

Suppose if the Reliance Stock falls Rs.100 than the Sensex will fall 600 points and vice versa. Companies having a medium to small size market cap than Reliance will influence the Sensex and Nifty less.

Thus, This is how the stock indices work…. And that’s why people should not consider only the stock market indices for their Investment Decisions.

I thought that, Readers of this Blog don’t want to know this fact about Indices. So I have never created a post like this. But I am very Thankful to you that You have raised this Question. Your Question will be helpful to gain the knowledge of several other readers of this Blog…

Thank you very much for interacting with this Blog….Keep Asking Questions….!!!!