Making sense of the Sensex

The Bombay Stock Exchange's Sensex, the most-monitored index of stock prices, exaggerates volatility. MONEY TODAY dissects it to show you how.

By Sameer Bhardwaj and Narayan Krishnamurthy         Print Edition: September 20, 2007

Have you ever felt smug at seeing your stocks rise or remain steady even though the Sensex was declining? Or the frustration when your stocks were not moving even though the Sensex was charging full steam ahead?

During the past few years, there were times when ordinary investors experienced such divergences between the movement of the Sensex and the values of their stock portfolios.

This seemingly puzzling phenomenon is rooted in the structure of the 30-share benchmark index of the Bombay Stock Exchange (BSE). The Sensitive Index—or the Sensex, as the world knows it—is a weighted index.

It assigns different weights to the 30 constituent shares depending on the past three months’ average free-float market capitalisation. Free-float is the portion of a company’s equity that is normally available for trading.Sensex will rise if...

Basing the weights on free-float, market capitalisation also means that the most widely held and most widely traded company will be given more weightage in the index.

While that is a desirable outcome, this tends to skew the benchmark index. For instance, the top three Sensex shares—Reliance Industries, ICICI Bank and Infosys— account for more than 30% of the index.

The top 10 shares control over 65% of the Sensex while the bottom 10 have a combined weightage of only 11.66%, less than the weight of Reliance Industries alone.

Note the irony of this statistical lopsidedness. The Sensex is the most widely used yardstick of the Indian stock markets. Millions of investors base their investing decisions on its movement. They get hustled by even minor swings in the Sensex value. How many of them know that only 10 shares control 65% of the index?

Also, investors often forget that the Sensex is not the only driver of the markets. There are other, more representative indicators of the broader markets.

For instance between 1 January 2003 and 30 August 2007 the BSE Sensex has risen 346% compared with a 396% rise in the broader BSE 500.

MONEY TODAY worked out a hypothetical scenario to calculate how much of a rise or fall in the value of the top five shares would push the Sensex up 200 points or pull it down 100 points.

In a controlled environment where all other Sensex shares remain unchanged, a 10% jump in the price of Reliance Industries will push up the index by 200 points. On the other hand, the bottom 10 shares in the index will have to rise by 10% each to be able to achieve this.Sensex will fall if...

This also raises questions about the suitability of using the Sensex as a barometer of the market. After all, with only 30 shares, it cannot be as representative of the market as it is made out to be.

With thousands of stocks trading, the “market” is a slippery notion. But the Sensex allows and enables the investors and mere observers get a measure of the market, get a sense of how the market constituents are performing.

To be fair, the Sensex wasn’t designed to be a retail investment guide. It was designed as a sensitive index. To that end it consists of liquid stocks with large market capitalisation. Its 30 stocks represent major industries such as finance, technology, oil, consumer goods, hotels and telecom.

Whatever happens in the market, it is reflected in the prices of these stocks. As a result the Sensex has a hair-trigger sensitivity to any event that has a bearing on stock price.

During market hours, the lasttraded prices of index scrips are used to calculate the value of the Sensex every 15 seconds and disseminated in real time.

However, investors need to get over the temptation of constantly looking at the Sensex movements. Buying and holding has worked wonders for long-term investors, something that investment gurus have always professed.

Pick a stock with a sound business, great prospects, a management to make the most of it, and you are very likely to see excellent long-term capital appreciation.

As investment expert Warren Buffett has said, the compounding effect of growth is the key to long-term profits in the stock markets.

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