The Mystery about Sensex

I really wonder why people in India always talk about Sensex without knowing what it is and what is indicates ? Forget about common people, even news channels and financial newspaper always talk about Sensex. Most of the time if you switch to a news channel, they would be talking about Sensex going up or down and predicting India's economic condition by analyzing the Sensex. Sensex is the most tracked and the most talked about index in India. But what is surprising is that it is also least understood index.

What is Sensex ?

Sensex stands for Sensitive Index which is used for Bombay Stock Exchange (BSE). Sensex which is also popularly known as BSE 30 in the financial world is a free-float market-capitalization of 30 well established companies listed on Bombay Stock Exchange. In other words, Sensex tracks price movements of 30 stocks on BSE. During market hours, prices of the index scrips, at which latest trades are executed, are used by the trading system to calculate Sensex  every 15 seconds and disseminate in real time. Sensex makes sense only for Index Fund managers and I don't understand why common man worries about Sensex. Sensex is just a virtual show window of Bombay Stock Market.

Sensex Calculation :

Foremost question which arises is how are these 30 companies selected ?
The top 30 companies with highest free market capitalization are selected. Free market capitalization considers only the shares which are not locked in or the shares which are available for trading. It excludes the shares which are locked by promoters or other strategic investors which can not be traded.
So,
 Free Market Capitalization = Total shares available for trading X Current Market Price

Its clear from the above formula that free market capitalization is dynamic due to the changing market price.
BSE reviews the list of stocks periodically. This essentially means that some stocks are moved out of the Sensex calculation and some are moved in after every review. The 30 stocks selected by the above process are given some weightage  as per its free market capitalization. The base value of Sensex is 100 as of April 1, 1979. The level of the Sensex at any point of time thus reflects the collective free float value of 30 component stocks, relative to the base period. So, a Sensex level of 30000 indicates that the Capitalization of current top 30 stocks is 300 times the Capitalization of top 30 stocks as of the base year.

Myths about Sensex :

1. Sensex mirrors the performance of all the sectors in the Indian ecomony.

The top 30 companies used in the calculation of Sensex do not have nay sectoral quota. These 30 companies mostly include IT companies and Oil & Natural gas companies. Sectors such aviation, gem processing do not have any representation in the Sensex. Hence Sensex can't indicate the performance of all the sectors in the Indian economy.

2. Sensex is an indicator of India's economic growth.

Often Sensex is taken an indicator of India's economic growth. It should be noted that Sensex tracks only the companies which are listed on Bombay Stock Exchange (BSE). Many Indian companies are not listed on BSE. Hence it foolish to consider Sensex as a true indicator of India's economic growth.

3. Sensex tracks performance of all companies listed on BSE.

Sensex tracks only a small set  of 30 companies with the highest Market Capitalization, but there are around 3600 companies listed on BSE. So, even if Sensex rises, many listed individual stocks may have lost value and this scenario has happened many times. In fact on October 29, 2007, The day Sensex touched 20000, 2123 out of 3113 companies declined in value. 

4. Sensex captures price movement of all these 30 companies.

Again wrong. The 30 companies used in the calculation are not given equal weightage. In fact, top 30 companies used is the calculation of Sensex have more than 65% weightage. Thus the rise and fall of these 10 stocks considerably impact the rise and fall of Sensex than the last 20 stocks.

Conclusion :

Sensex is not an unbiased true indicator of top 30 stocks listed on BSE let alone entire stock market and Indian economy. Retail investors should not look at the Sensex and rush into investing in the stock market. A little known fact about Sensex is that its base year has been changed (it was decreased). So, just by decreasing the base year, you can raise the Sensex and this was exactly the motive behind decreasing the base year. The top 30 companies which are used in the Sensex calculation today, were not even present at the time of the base year. So, whats the purpose of this index. In my opinion this base year should be raised at least to the nineties to make some sense.