How Does The Stock Market Work? – Part 5
This is the fifth and final part of our journey to understand how the stock markets work. In the previous articles (Part 1, Part 2, Part 3 and Part 4) we saw how B&T grew and rewarded its shareholders handsomely.
Similar to B&T, a number of companies list on the stock exchanges to raise money from the general public. Over 5,000 companies are listed publicly on the stock exchanges in India. Primarily, there are two exchanges in India – The Bombay Stock Exchange (BSE) and The National Stock Exchange (NSE). There are some other exchanges, like Calcutta Stock Exchange etc., which are more or less insignificant as compared to these two exchanges.
All the activity related to the stock market is governed by Securities and Exchange Board of India (SEBI). SEBI is the regulator and exists to protect the interest of retail investors, promote the development of the stock markets, and regulate all the activity in the stock market. These two exchanges – BSE and NSE – are also governed by the SEBI.
Stocks are traded on the two exchanges, from where you can buy or sell any stock you want. These transactions must be done via a broker. This means you open an account with a broker, the broker gives you a demat account – where all your stock holdings like B&T are stored.
Now there comes a concept of index. Both BSE and NSE have a flagship index in Sensex and Nifty50 respectively. These are the two terms which most of you must have heard. Let’s get into detail about what they really mean.
Both the exchanges filter out a certain number of stocks (30 in Sensex and 50 in Nifty 50) and put them into their respective index and assign a weightage to each stock. So when these individual stocks move, the index moves as a combination of the movement in all these stocks.
As on July 31, 2020, the top 10 stocks of the Nifty 50 index by weightage:
Similar to this index there are various indices which exist both in BSE and NSE like sectoral indices, quality index etc.
The good thing about these indices is that they get updated every now and then. If any company is performing poorly, it is thrown out and replaced with a better one. Recently, Vedanta was thrown out of the Nifty 50 index, and was replaced by HDFC Life.
The advantage of this is that only good performing companies stay in the index. Since the Nifty 50 index was launched in 1996, only 7 companies that were a part of the index, still continue to be a part of it. This means that over a period of 24 years, multiple companies have been replaced from the index, and only these 7 have survived in the index. Over this period, Nifty 50 has become almost 12 times, giving around 11% CAGR without considering dividends, which has not only beaten inflation, but also other asset classes like PPF, FD etc.
I hope you would have now got a fair idea of how the stock market works and what exactly is an index.
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