We keep hearing about NIFTY and SENSEX in newspapers and TV. When I was a kid, way back, I remember the newscaster talking about Sensex on Doordarshan almost every day.

So, what exactly is Sensex or Nifty?

For understanding that, we first need to understand the concept of an Index.

Index:

Let’s say you went to a supermarket for buying fruits and vegetables. To know whether the fruits there are fresh or not, are you going to check each fruit there? No, right?

What you would do normally is check may be one or two apples, a couple of bananas or a few strawberries and based on that, you will decide whether the fruits are fresh or not.

In the same way, if you want to know how the stock market is doing, you cannot possibly go check every stock listed on the stock exchange because there are thousands of them.

Instead, what you would rather do is to pick a sample of stocks that are representative of their sectors and see how they are performing.

This sample of stocks is called “Index” and the companies that make up that index are called Index constituents.

An index is comprised of stocks selected from all the major sectors such as IT, Pharma, Automobiles, Banking, Energy etc. Hence, when we are looking at the index, we are essentially looking at a representation of the overall market.

The concept of an index is used in every country, you might know these famous stock market indices.

• Dow Jones and Nasdaq from the US stock market
• FTSE is the index of the London Stock exchange
• CAC is a French index
• Nikkei from Japan
• Hang Seng from Hong Kong
• SENSEX and NIFTY from India

In India, there are two major stock exchanges: Bombay Stock Exchange or BSE and National Stock Exchange or NSE.

• SENSEX is the index of stocks listed on BSE and
• NIFTY is the index of stocks listed on NSE.

SENSEX:

• Its full name is Sensitive Index but it is popularly known as “SENSEX”
• Initially compiled in 1986, SENSEX is probably the most widely recognized index in India. SENSEX has performed well since its inception.
• There are about 6000 stocks listed on BSE.
• Out of these 6000 stocks, BSE selects 30 stocks to form SENSEX. In other words, BSE believes that these 30 stocks represent the best and brightest in their respective sectors.

How do you pick these 30 stocks to represent 6000 companies?

Well, for that, BSE picks companies with very high market capitalization, high trading frequency, high average daily trades to ensure liquidity, daily turnover and of course industry representation.

The price of SENSEX is calculated based on the share prices of these 30 stocks.

So, if the prices of the majority of these 30 stocks are going up, SENSEX will also go up AND we say “market is up or the market is in green.” And, if share prices of the majority of these 30 stocks are falling, SENSEX will also fall and we say “market is down or market is in red”.

NIFTY:

Just like SENSEX is the index of the Bombay stock exchange, Nifty is the index of the National Stock Exchange.

• Its full name is National Stock Exchange Fifty (fifty because NIFTY consists of 50 stocks) but it is abbreviated to NIFTY.
• There are about 2000 stocks listed on NSE.
• Out of the 2000 stocks listed on NSE, the exchange picks 50 stocks to become part of NIFTY.

The selection criteria are pretty much the same as that of SENSEX. Remember that all the big companies in India are listed on both the exchanges and therefore all the 30 stocks that constitute SENSEX are also part of NIFTY 50. Nifty has 30 more stocks.

Rebalancing of index:

Now, just because a company becomes part of SENSEX or NIFTY doesn’t mean that it will stay there forever. The fact is that it is a very competitive environment and only the best-performing companies get to stay in the index. Twice a year some companies get kicked out of the index and new companies are added to the index. This process of keeping only the best-performing companies is also called Index Rebalancing.

How are the prices of SENSEX and NIFTY calculated?

At the time of compiling this article, NIFTY was at around 11,000 and SENSEX around 37,000. So, the question is: “what’s the calculation behind these numbers?”

SENSEX and NIFTY are calculated on what is called the “free-float market capitalization” methodology.

We don’t just add the prices of these 30 stocks to calculate SENSEX.

We follow these 3 steps:

Step 1: Calculating the market capitalization of each of these stocks, which is “Market price X shares outstanding.”

This ensures that a company’s weightage on the index is in proportion to its size. For example, IndusInd bank(90,000 Cr.) will have a lower weightage than Reliance(1,50,000 Cr.).

Step 2: Multiply this number by “Free Float Factor”.

Free Float Factor: The market cap can be broken into two components: The first is the shares that are held by the general public like you and me (Called the Free Float market), and the Second is the shares that are held by promoters. While calculating the index, we only consider the free-float market cap and not the promoter holding. This is common practice across the world to make sure that a handful of people – the Tatas, the Ambanis, and the Birlas- won’t have disproportionate power of moving the market which can potentially hurt the common man.

Step3: Once we have the free-float market cap, we just add them up and then adjust them with the index value in the base year and we get the current price of Sensex or Nifty.

Importance of Index:

• Index acts as a reflection of a country’s economy. Watch the video above to find out the performance of each Index.
• Another frequent use of Index is in Benchmarking, which is comparing the return of the stock market with other asset classes. For example, you can compare the returns of the past 1 year and let us say the property gave 5% appreciation, fixed deposits in the banks gave about 8% and if Sensex gave a return of 10%, we can safely infer that the stock market overperformed other asset classes.
• An extremely important practical application of index is in Mutual funds called “Index Funds”. Index funds have a simple job: just keep mirroring the Index.
• Hedging

Hope you understood the concept of Index, Sensex and Nifty, their calculation and their importance.

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