How is the market?
This is the first question that any investor asks his broker. Why should an individual investor, even if he does not own a single stock , 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 behavior. Hence, it is tracked globally to gauge market moods. The BSE Sensex or the NSE 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.
Don’t put all your eggs in one basket
Risk optimization 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.
Where is an Index used?
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.
The importance of global indices
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 have an impact on local market movements.