If you are fed up with the stock market, I can see why. The performance of the FTSE 100 during the last ten years has been dire, as this graph shows.
According to the latest Barclays Equity Gilt Study, the real returns from UK stocks during the ten years to 2011 were just 1.2% per year. So if you invested in a UK market tracker fund then you have barely preserved your money after inflation. Gilts and index-linked bonds were better places to be, giving you real returns of 3.9% and 4% per year respectively. Meanwhile, precious metals such as gold have been stellar in comparison.
So should you stay clear of stocks? No, but it pays to be selective about how you get your stock market exposure.
Our unhealthy obsession with indices
The problem for private investors is the way the mainstream media conditions us to think about the performance of the stock market. Most days on the news we are told the closing value of the FTSE 100. Many commentators seem pre-occupied with the value of indices.
The financial industry is no different. You can give your money to an active fund manager who tries to beat a benchmark index of stocks. Alternatively you might buy a tracker or exchange traded fund (ETF) that attempts to passively mimic the performance of an index.
I am not sure this obsession with indices is good for long-term investors. Here are three reasons why.
An index may be unbalanced
A big problem is knowing what exactly you are tracking, or benchmarking. Have a look at the chart below – it shows you the make-up of the FTSE 350 index – a basket of the 350 biggest stocks on the UK market.
Make-up of FTSE 350 (%)
As you can see, half the value of the FTSE 350 comes from just five sectors. Over a third comes from economically sensitive sectors such as oil & gas, banks and mining. If you own a tracker fund or an active fund that hugs the index (as many of them do) then this is what you will effectively own.
This is hardly a balanced portfolio, yet many in the fund management industry kid themselves (and you) that tracking the FTSE350 is a very low risk way to invest. It’s not.
Further, index funds and closet indexers in the active fund management industry buy stocks on the basis of their size, not necessarily because they are good investments. It often leads to the opposite of good investing sense in that these funds buy high and sell low – large market capitalisation stocks tend to be fully priced, yet an index fund will pile in anyway. The result is you end up owning the big guns such as Vodafone and Facebook at just the wrong moment.
You may sacrifice capital appreciation
One of the reasons the FTSE 100 has gone sideways for the last 10-15 years and why it may not make much headway for a while yet, is it’s stuffed full of large cyclical stocks and mature companies.
The law of large numbers means that many of these stocks have actually arrived at their steady state and cannot deliver fantastic rates of growth anymore. Some may pay generous dividends –and there’s nothing wrong at all with that – but don’t expect much capital growth as a whole.
You may overpay to own the market
The other point to make is that the stocks that make up the UK market are not that cheap either. Some might claim that they are, as they trade on just under 11 times earnings and are some way below long-term averages. But this is pretty misleading. The energy, mining and banking stocks that make up over one third of the market should be low p/e stocks given their risks. Indeed, many quality blue chip shares are actually quite highly valued.
If we turn to dividends, then UK shares look neither cheap nor expensive. Earnings can be manipulated, but dividends represent hard cash returns to shareholders. As you can see from the chart below, on the basis of dividends, the market is not compellingly cheap, as it was in, say, 1979-80.
UK stockmarket dividend yield (%)
So what should you do instead?
I don’t believe that blindly buying a stockmarket index is sensible in the current climate. You must first decide what you want to achieve by buying shares. Then I’d put together a share portfolio with equal amounts in, say, ten different sectors. The portfolio can then be set up for income or capital growth or both. We’ll give you some specific ideas on how you can do this in a future article.
Alternatively, you could put your money in an investment trust such as long-term MoneyWeek favourite Personal Assets Trust (LSE:PNL). This fund has a proven track record of using stocks as part of its investment approach to protect and grow your savings. It does not hug an index, nor is it ever 100% invested in stocks. You could do worse than follow its example.
Disclosure: I own shares in Personal Assets Trust.