There are 4000+ companies listed on the Stock Exchange. Trying to keep up with all of them all can get tough. That’s why we have Nifty & Sensex, two popular market indicators made from selected listed companies. These help us understand the overall economy and market performance.
Hello and welcome to our new series - Learn With Upstox. Here, we shall try to make investing easy and simple. Whether you want to invest in IPOs, Mutual Funds, Digital gold, Stock market or Real estate, don’t worry because we are going to discuss about all these topics here.
And the topic for today is - What is Sensex and Nifty?
You must have heard things like the sensex is above 50,000 or that the Nifty is 15,000. Well, what does that mean? Why does it go up and down? How do we interpret it? And Why is it important?
In this article, we will talk about it in detail so let’s not wait any longer.
To understand this better let’s take an example.
Example
We know that before the results of elections are out, Exit Polls are announced. But why? This is done so that we get a rough idea of where the election is headed. Now, do these polls always make the right predictions? No. They are right around 60% to 70% of the time, but not always.
Why? Why aren’t these polls always right? Because exit polls make predictions based on a small sample size. As in, if lakhs of people are voting, some of these people are grouped together and asked as to whom they voted. On the basis of this data, a prediction is made as to whom the other lakhs of people might have voted. Sometimes, this small sample of people matches the actual population, while other times it doesn’t represent the whole scenario.
Similarly, More than 4000 companies are listed in the Indian Stock Market. And obviously, nobody can check the prices for all these companies every single day. But you also have to know if most of the companies are rising or falling today. So basically, you need an approximate idea of where the market is headed today? How is the market sentiment ?Are a majority of the companies going up or down?
This is exactly where Sensex and Nifty are useful. They are kind of like exit polls as they try to predict where the market is headed based on a small sample size.
Sensex and Nifty
Sensex is a pool that comprises 30 companies, whereas Nifty is a pool that comprises 50 companies. They both give an opinion as to where the market is headed on a particular day.
The 50 companies that are listed on Nifty are the biggest companies in India. The direction which these companies go in on a particular day usually represents where the other companies will go. But it’s not true that this happens everytime.
They are right for around 60% - 70% of the time. But it’s not that Sensex and Nifty are 100% reliable. It just gives you an overall idea of where the general market trend is.
The Formation of Sensex and Nifty
We have seen that Sensex comprises the top 30 companies while Nifty comprises the top 50 companies.
Let’s look at Sensex first.
Sensex
Sensex comprises the top 30 companies according to the Free Market Capital.
First, let us understand.
What is a Market Capital?
Suppose that there is a ‘Company X’ in the market. The price of one share of this company is Rs 50 and the total number of shares of this company in the market is 1000.
Therefore the market capital of this company will be the Price of one share multiplied by the total number of shares.
(Market Capital = Price of share x total no. of shares)
Therefore market capital of Company X = 50 x 1000 = Rs 50,000.
To come under Sensex, the market capital isn’t calculated. What is calculated is the Free Float Market Capital.
What is a Free Float Market Capital?
Free Float Market Capital is the number of shares left after we subtract the shares which are held by the owner of the company. So,
Free Float Market Capital = (Total no. of shares - the shares with the owner) x price of one share
Let’s take the same example. Assume that the Company X, which we discussed earlier, has 1000 shares in total. Of these, 600 shares are owned by the owner of the company. We also know that the price for each of its shares is Rs 50.
Now, the Free Float Market Capital will be = (1000 - 600) x 50= Rs 20,000
Therefore, those companies are listed on Sensex, whose Free Float Market Capital is the highest. The group of these 30 companies is basically called the Sensex and these companies belong to different sectors. In India, the financial services sector like Banks or NBFCs holds the highest weightage in Sensex. After that, the second highest weightage is that of IT companies followed by other sectors. The fluctuation of Sensex depends on how these companies are doing on a particular day.
Nifty
Unlike Sensex, Nifty has 50 companies which have the highest Free Float Market Capital. The main difference between Sensex and Nifty is that sensex comprises 30 companies while nifty comprises 50. It is because of this difference that they both don’t show the same movement. Say, if some day the Sensex is 1% up, it is possible that the nifty will be only 0.5% up because it has 20 companies more and its movement is also decided by these 20 companies.
Now we know that Sensex and Nifty give an outlook of the Indian market which is reliable to an extent and saves a lot of our time. These indexes become even more reliable when there is a lot of movement. If, on some day, the Sensex and Nifty are very high, we can say with surety that the market is going to be really good today.
We’ve seen the advantages of these indexes. But now, let’s take a look at their disadvantages.
Disadvantages of Index
- This index doesn't include the biggest companies. They only include the companies whose Free Float Market Capital is high. For example, Company A has a market capital of Rs 1000 crore, but 70% of its shares are held by the owner. Which means that it’s free float market capital is Rs 250 crores. If you take another Company B, assume that it’s market capital is Rs 500 crores. The owners hold 10% of it’s shares and therefore the free float market capital becomes Rs 450 crores. And therefore, even if the market cap of company A is twice that of company B, it will still get less weightage in Nifty because it’s free float market capital is lesser. And this doesn’t always give a clear picture.
- The second limitation is that only 30 or 50 companies are pooled in this. Which means that we are trying to get an idea for all the companies in India, small or big and irrespective of it’s sector based on this small number.
- The third limitation is that of the Survivorship Bias. It means that continuous bad performance of the 30 listed companies in Sensex will lead to their removal from the list. A new list will replace this one. The companies which are added are usually really big and it's very likely that they keep performing well. Which means that the index will keep showing a positive trend. The problem with this is that, if slightly smaller companies aren’t performing growing that well or that fast, then this will never be represented on the index and it will fail to give a clear picture of the market. This revision where bad performing companies are removed and replaced by better performing companies takes place on a quarterly basis. Therefore, Sensex or Nifty only shows us the winner’s data. This survivorship causes a feel good bubble as if everything is going alright.
That is why you should not always compare your returns to the index.
So, will it be beneficial to invest in the companies listed on the Index?
Remember, that Index only has those companies which performed very well in the past three months. Which means that if you want to invest in it once it is listed, it’s shares will already have become quite expensive. And therefore, it might not hold a lot of growth potential any more. It could also be over priced, because now it's well discovered.
But if you can identify the winners beforehand, only then you can earn a maximum profit. So, it's really good if you can identify the companies which can be listed next year. And don’t compare your portfolio returns with sensex or nifty in the short term. It is always good to research quality stocks because even today there are many good stocks in mid cap and small cap companies which are undervalued and might even get listed on the index in the coming years.
And that’s all for this article. We hope that we could provide you with the right information and that it helped you understand Sensex and Nifty. If you liked this article and want to read more about these topics, feel free to surf our blog because we have an entire series on this. In fact, you can even check that out on our YouTube Channel.
Thank you and have a great day!