Published by OAK TREE PRESS, 19 Rutland Street, Cork, Ireland
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© 2012 ILTB Ltd. (trading as GillenMarkets)
A catalogue record of this book is available from the British Library.
ISBN 978 1 78119 003 6 (Hardback)
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ISBN 978 1 78119 005 0 (Kindle)
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Stock market investing carries risk and there is no guarantee that any of the approaches to investing outlined in this book will continue to work in the future. None of the approaches work all the time and there are several instances where individual approaches have lost money in particular periods.
Thus, neither the author nor the publisher assumes liability for any losses that may be sustained by use of the approaches outlined in this book, and any such liability is hereby disclaimed.
To Frances, for all her patience, and three great children, Darren, Aoife and Clodagh, who will soon be heading out into the real world.
I also must acknowledge contributions from several trusted colleagues, respected investors and successful authors in their own right. In particular, for reviewing early editions of this book and for providing essential feedback that was not only needed but of immense assistance, my thanks to Paul Callan, former Director, Global Equities, Zurich (Ireland), Jim Slater, author of The Zulu Principle (among several other investment books), Harry Sheridan, former Finance Director, CRH plc and John Shiel, business consultant. Thanks to Jack Schannep, editor of thedowtheory.com website and author of Dow Theory for the 21st Century, for the valuable contributions he made to Chapter 22: Timing the Markets, without which that particular chapter would carry much less weight.
In planning the book I commissioned a short story (A Villa in the Sun, which appears as Chapter 26) from Virginia Gilbert, a BAFTA-nominated, award-winning writer and director, in order to illustrate the very real dangers of speculating in markets (as opposed to investing). While having little previous experience of the workings of the financial markets, and after just three short meetings, Virginia has expertly captured the impulses that drive many would-be investors to take short cuts which, rather than improving returns, can lead to unnecessary losses, and sometimes worse.
Last, but by no means least, my thanks to Brian O’Kane of Oak Tree Press who didn’t flinch when I had to do a complete revamp on the initial edition of the book.
The aim of this book is to demonstrate that becoming a successful do-it-yourself (DIY) investor is within the reach of almost every person in society. The global credit crisis of 2007-2009 left most investors – even professional investors – with deep scars. It also provided would-be investors with reasons to remain on the sidelines. However, if our aim as investors is to increase our understanding, to take control of our own finances and investments, then the 2007-2009 years provided us with an important lesson: that an understanding of risk, and control of risk, is as important as our search for returns.
Stock markets can be a rollercoaster. Downturns bring volatility and uncertainty, which can impact on your confidence, judgement and desire to invest in a certain asset class. Bull markets do the opposite and bring over-confidence, tricking you into overlooking fundamental information. To maintain and grow your assets consistently, you need an approach that controls risk, reduces emotion, can be managed in a busy life and takes account of the significant volatility that is part and parcel of stock market investing.
Regardless of whether you are a novice investor and just getting started, someone who already invests in the stock markets, or someone working in the financial services industry, this book aims to improve your understanding of what is required to make a success of investing.
Saving or investing in the stock markets is for everyone – from parents with the children’s allowance, to someone who has a lump sum to invest, to the person who has just started working but can save even €100 a month, to someone who is free to manage their own pension. Building an asset base from which you can earn income gives you choices later in life. My aim is that, when you close this book, you should be able to implement an easy-to-follow approach to investing in the stock markets, whilst minimising risk. No matter what level of experience you are starting from, this book is aimed at assisting you to obtain the returns on offer from the markets over time.
The advent of low-cost, online dealing has substantially lowered the cost of investing in markets. The Internet also has made it easier to access independent investment advice. If you wish to be a DIY investor, to reduce your reliance on product sellers, then the tools are now readily available to you.
APPROACHES TO INVESTING IN THE STOCK MARKET
Arming yourself with a proper strategy or plan, which dictates what you buy and when you sell, is the key to stock market investing, and developing one is a good deal easier than you may think. That plan might be simply to invest across the different asset classes where there appears to be clear value on offer; to concentrate on high yielding funds listed on stock markets as a method of generating income, while controlling risk; or to master some successful approach to stock selection similar to the one I outline in Chapter 21, Value Investing in the FTSE 100.
Most private investors underestimate the challenges of identifying suitable individual companies (shares) to buy and when to sell them. This book outlines why this is and offers an easy-to-follow mechanical approach to selecting a diversified portfolio of stocks from the UK FTSE 100 Index, an index that represents the 100 largest companies listed on the London Stock Exchange by market capitalisation.
Whichever approach you choose, you must realise that there is no silver bullet for investment success. You must have a plan, keep your emotions under control and have the discipline to adhere to your plan over time.
Over the years, the question that I have consistently tried to answer is: how can the ordinary private investor succeed with limited time, little understanding of company accounts and no access to management? For that is the true test as to whether stock market investing is for everybody or just the knowledgeable few.
Always bear in mind that it is the companies that produce the returns that the stock markets deliver, not the professional fund managers, not the speculators, not the media or individuals with inside information. It is the companies that generate the returns, and those returns reflect the growth in their profits, cash flows and dividends over time. You simply have to own a diversified list of them, either directly or through funds, to obtain those returns. Many private investors fail to do just that. For a variety of reasons, they get side-tracked.
You will learn also how to invest in the stock market indirectly through listed funds, such as exchange-traded funds and investment companies, which offer instant diversification, allowing you to more easily control risk.
Risk assets might be defined as those assets that do not offer a guarantee of your capital back but which have provided returns well above bank deposits to investors over the long-term. Equities (shares) are a risk asset, and have delivered returns of 9% to 10% per annum (before costs) over the past 100 years, or 5% to 6% annually above inflation. In contrast, short-term deposits with the banks have delivered circa 1% annually above inflation. Here lies the reason for investing in risk assets: the returns have been higher over the medium-to-long-term. They are not higher every year or indeed in every decade. For example, the 2000s have been miserable for investors in equities in the developed markets. But, as I will point out later in the book, this is because equities in the major developed markets simply were overvalued to start with in the late 1990s. We also will examine how that was relatively easy to see, even if the majority of investors ignored the signals at the time.
There are several factors that mitigate success in the stock markets. Our educational system does not even begin to equip us for what is one of the most important aspects of our lives – the management of our savings and pension monies. In many countries, the financial services industry serves the consumer poorly, often through the promotion of speculation rather than investment or by a focus on selling products as opposed to providing advice. Also, the menace of stock market volatility can all too easily play on our emotions and force errors, when none need be made. For these and other reasons, stock market investing needs to be learned.
We might ask ourselves what has driven progress over time in the developed, and now developing, economies and markets. The answer, of course, is the entrepreneurial spirit that is expressed through business – and the stock market is made up of a collection of publicly quoted businesses, as well as funds and financial instruments of one form or another. People trade with each other, from which businesses develop, and businesses drive the economy forward. Rising profits drive business values upwards over time. This, in turn, lifts incomes in society. Incomes underpin property prices, and higher incomes underpin rising property prices. So, property is secondary to business, for if we have no businesses we have no income to spend, or to invest in property.
It requires confidence in the future of the economy to believe that property and stock market values will rise in the years ahead. In democratic and pro-business economies, this confidence normally has been well-placed. In the past 10, 20, 50, 100 years or longer, developed economies such as the US, the UK, mainland Europe, and now many emerging economies, have made dramatic progress, despite the intermittent downturns. Wars aside, the probability that this will continue to be the case in the future is high. That said, Japan is a modern-day example of where it has simply not paid to invest in either the stock market or property over the past 20 years. Deflation gripped Japan and only non-risk assets, such as cash deposits and short- and long-dated government bonds have rewarded investors in Japan since early 1990.
Everyone can use the stock markets to invest for the future and to build wealth. And in the stock markets, you can start small – very small. You cannot do that when investing in physical property. In the stock markets, you can build an asset brick-by-brick, investing only when you can afford to and without any debt. My experience tells me that the majority of private investors feel that the stock markets are complex, and, consequently, are scared to get involved. This book hopefully will demonstrate to you that what you believe to be a complex subject can, in fact, be quite straightforward once you clear away the fog.
DEBUNKING SOME MYTHS
This book will de-bunk various stock market myths for you. Many private investors think that it is necessary to be an expert in stock market terminology; this is not the case. Some feel the stock markets are only for those with money; they are not. A great advantage of the stock markets is that anyone, with even a couple of hundred euros to invest each month, can build an asset from modest beginnings.
Many believe that the stock markets are just for gamblers. It is certainly true that the stock markets can fulfil the gambling instincts in human nature, but the stock markets are first and foremost an investment forum. As an owner of shares (directly or through funds), you are a part-owner of businesses and, if they prosper, so too should you. In other words, returns accrue naturally to the owners of assets, but not so easily to the traders of assets.
Finally, many are convinced that you have to predict which companies are the best to own, in order to make a success out of stock market investing. Nothing could be further from the truth. It should be a great relief to know that you do not have to predict anything to invest successfully via the stock markets.
COMMON INVESTING ERRORS
Many investors fail to plan their finances and to properly and honestly appraise their own risk tolerance. The balance to be achieved between investing in non-risk assets and risk assets is a personal one and must take several variables into account – like the sustainability of your income, the mortgage on your house and whether your pension is adequately provided for, among other issues. Many investors fail to adequately diversify either within an asset class or geographically. The herd instinct in human nature leads many to invest late in a popular asset class. More times than not, by that time the asset class is already overvalued, which leads to disappointing returns thereafter.
Without a proper plan, many end up speculating in markets rather than investing, and there is a world of difference between the two. Also, many investors fail to distinguish between a temporary loss and a permanent one. We will examine all these common investing errors at various stages throughout the book.
3 STEPS TO SUCCESSFUL STOCK MARKET INVESTING
I believe – and have been teaching for several years – that there are only three steps required to make a success out of investing.
The first step is to have the patience to let compounding work its magic over time. You cannot compound from zero, so you need to start somewhere and then have some patience. Generating a return of 8% per annum will turn a €250 monthly investment programme into €19,008 after five years. After 10 years, your capital will grow to €46,936; after 15 years, it will be worth €87,973; and after 20 years, €148,269.
If you can save a portion of your earnings each month, over time, you will build an asset for yourself with no debt attached. The size of that asset depends on several factors: what you put into it, how long you commit to it and the returns available from the asset class(es) you are investing in. If you can accumulate an asset base from which you can generate an annual income, then you are well on your way to achieving financial freedom.
The second step is to adopt a tried and tested approach to investing that has at its core an emphasis on value. For it is the value on offer in the asset you buy that largely determines the subsequent returns over the medium- to long-term.
I started out in the industry thinking that the more time and effort I put in, the better an investor I would be. Ten years later, I realised that a couple of hours a year spent selecting a portfolio of stocks or funds using certain simple but strict financial criteria to ensure value and diversification is more effective than all the hours of labour I used to put in.
In addition, any good approach to stock market investing must reduce the normal emotions of fear, greed and hope that lie within us all. Our emotions and a lack of understanding are the real enemies, but both are easily overcome with greater awareness and having a plan to follow.
The third, and final, step is to avoid letting volatility interrupt your savings or investment plan. The stock markets are volatile – sometimes violently so – and definitely more volatile than direct property investing. Investors must acknowledge this and have a plan that protects them from getting knocked off course by stock market volatility. This, in turn, will assist you to avoid turning a temporary loss into a permanent one.
You will come to understand that you have natural advantages over the institutional (professional) investor and that success accrues to the well-prepared investor but rarely to the speculator, who, too often, wants only quick results. The investor owns assets and benefits from the natural appreciation in the value of stock market and property asset values over time. The speculator trades assets in the search for short-term gains. But he is playing a zero sum game, as one trader’s gain is another’s loss. Many private investors become frustrated and mistrustful of the stock markets, and it is often because they have been speculating rather than investing, without understanding the difference.
There are not many people capable of learning in a vacuum, and nowhere is it more important to educate ourselves than when investing in the stock markets! We are not born with a natural understanding of investing, and it makes sense to take the time to learn, and to practise what we have learned. Few people on their first outing on a golf course hit a good drive down the fairway. Taking a few lessons, and putting what you have learned into practice, is the key to becoming a better golfer. You should have the same attitude to investing.
THE STRUCTURE OF THE BOOK
Section 1 of the book (Chapters 1 to 8) highlights the importance of personal financial and investment planning, outlines many of the common investing errors and provides an explanation as to why markets should rise over time. Also, this section highlights the power of compounding and explains how the phrase ‘long-term’ can vary depending on whether you are investing regularly (the regular investor) or at a point in time (the lump-sum investor). In addition, we will look at why the markets are often volatile, clarify the difference between investing and speculating and examine how stock market investing differs from investing in physical property. Lastly, this section finishes off by looking at the significant hurdles the private investor faces when attempting to select individual stocks.
Section II of the book (Chapters 9 to 17) provides a detailed tour of the various asset classes available, and examines the historical returns that each has delivered over time and where the value might lie today.
Section III of the book (Chapters 18 to 24) deals with the various ways of gaining exposure to markets, and includes a detailed look at the two fund types listed on the stock markets: exchange-traded funds (ETFs) and investment companies. Then it outlines specific investment strategies in risk assets:
and deals with the practical implementation of each particular strategy.
Finally, in what is a break from the norm for an investment book of this type, I commissioned a short story, A Villa in the Sun (Chapter 26) from Virginia Gilbert, a BAFTA-nominated, award-winning writer and director, to drive home the often real consequences of speculating in markets rather than investing. Enjoy your reading.
Rory Gillen
Greystones, Co. Wicklow, Ireland
June 2012
SOME FUNDAMENTALS OF INVESTING
1: PERSONAL FINANCIAL AND INVESTMENT PLANNING
Before you consider investing in markets or, indeed, in physical property you should carry out an analysis of your own financial position and how it might look a few years down the road. The following factors are all relevant:
The fact is that some jobs are more secure than others and the security of your employment and sustainability of your income is an important part of a decision to invest in risk assets. Clearly, the greater the confidence you have in your income, the lower the probability (and risk) that you will have to change tack and sell your investments due to changes in your employment circumstances.
Many people consider their house to be an asset but that is rarely the reality. With a mortgage attached, your house is actually a liability; even when you have paid off the mortgage, your house cannot be considered a free asset in the sense that you can dispose of it and release funds. Some people do decide to trade down when their children have grown up and have moved out or when they are coming to retirement, but this is not the case for most people.
PAYING DOWN YOUR MORTGAGE MAKES GOOD INVESTMENT SENSE
It makes sense to pay down your mortgage to a sensible level (to say 50% of your house value) before committing yourself to investing in the stock markets. To be carrying any other debt and investing in risk assets should be avoided altogether. As we will see in Chapters 9 through 17, equities have delivered annual returns of 9% to 10% (before costs) on average over the long-term. However, this is a pre-tax return.
If you are paying an interest rate of, say, 4% on your mortgage or debt, then by paying down your debt you are saving this 4%. This is equivalent to roughly an 8% pre-tax return (if you are paying tax at 50%) as you are paying down the debt from post-tax income. Hence, by paying down your mortgage early, in effect, you ‘earn’ a high gross return but without investment risk.
Investing in risk assets is best done with surplus savings and not with debt. Investors in physical property have a difficulty in this regard because an investment in a property is normally a significant one and often has to be partially financed with debt. Property investors still can lower the risk of taking on debt by ensuring that there is a secure and meaningful rental income available from the property.
Your pension arrangements are also a material consideration. It makes sense to ensure that you are contributing to your pension from an early age, as your obtain tax relief on your pension contributions up to specific limits dependent on where you are resident.
Many people will be investing through their company pension, while others have the flexibility to manage their own pensions through self-invested personal pensions (SIPPs) in the UK, 401(k)s in the US and personal retirement savings accounts (PRSAs) or self-administered pensions (SAPs) in Ireland. These pension vehicles also allow you to self-manage your pension monies through a stock broking account, including online, low-cost stockbroking accounts.
RISK ASSETS VS NON-RISK ASSETS
As we will see in Chapter 9, Investment Choices and Returns, risk assets, such as equities and property, have delivered the best returns over the long-term but that does not mean you should automatically commit all of your surplus savings to them. There is no one right choice as each of us is different and has different needs, desires and pressures to cope with. For one person, it might be entirely appropriate to have all their assets in risk assets; for another, this might be entirely inappropriate. Aside from financial issues, there are other factors that may influence your decision, ranging from your age, your temperament and your risk appetite to your understanding of investing.
Any likely commitment to risk assets also will be influenced significantly by whether you are:
The lump-sum investor does not get to take advantage of lower prices and better values should they arise, whereas the regular investor does. Hence, the risks in stock market investing are different for both investor types and we will examine this issue in more detail in Chapter 5, Defining the Long-term.
2: COMMON INVESTING ERRORS
In the Introduction, I outlined a number of common mistakes that investors make, and we will now go through some of these errors individually:
INAPPROPRIATE USE OF DEBT
Investing in risk assets should be mostly done with surplus savings. Risk assets, like equities (shares) and property, have delivered returns well in excess of cash deposits over the long-term but they do not come with a guarantee. As I mentioned in the Introduction, investors seek returns but they must also control risk. Unless you are particularly skilled at understanding value, then adding debt to your investment programme just increases the risk.
Investors in physical property traditionally have borrowed to enhance returns. As we will see in Chapter 7, Stock Market and Direct Property Investing – Comparisons and Contrasts, rental income from physical property is generally more stable than corporate earnings. For this reason, the risk of using debt to buy property can be controlled so long as the investor obtains value. But, as we saw in the developed world in the 2000s, most investors failed to understand this, and many were highly borrowed against overvalued property, and thus were exposed to risk they did not understand.
A LACK OF DIVERSIFICATION IN RISK ASSETS
For the majority of investors, it makes sense to diversify. If you are investing in individual companies, then diversifying into a selection of companies in different industries and perhaps even across different geographic regions reduces the specific risk of any individual company underperforming, or perhaps even of it going out of business.
Diversifying across different asset classes offers you the opportunity to obtain returns from asset classes that are not particularly dependent on, or correlated to, the economy or economic cycle. Returns from hedge and absolute return strategies, commodities, precious metals and government bonds often are unrelated to the general direction of the economy, and therefore can generate positive returns when equities and property, which are highly dependent on the performance of the general economy, are performing poorly. In this way, diversifying across different asset classes can reduce risk.
SPECULATING RATHER THAN INVESTING
Warren Buffett, the iconic Chairman of Berkshire Hathaway, made the following comment in his 2005 Annual Report to shareholders1, and which I think neatly captures the difficulties faced by speculators in obtaining the returns on offer in stock markets:
Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, “I can calculate the movement of the stars, but not the madness of men.” If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.
Buffett is referring to the fact that too much trading activity is likely to lower the returns one can reasonably expect to obtain from the stock markets over time. Constant activity is the hallmark of the speculator, and, while the primary role of stock markets is to match the financing needs of companies with the investment needs of savers, the markets also fulfil the gambling instincts in human nature.
For many would-be and even long-standing private investors, the distinction between investing and speculating may be foggy but an understanding of the differences is critical to ensuring long-term investment success in the stock markets. The investor and the speculator may occupy the same space, but they go about their business in very different ways.
To be an investor is to be an ‘owner of assets’. By owning shares in businesses or properties, you are part-owner in them and should benefit from the returns on offer over time. All investors can make these returns, just as they can, and have done, with physical property.
In contrast, the trader or speculator is looking for gains over shorter time horizons and, therefore, does not have the time to benefit from the underlying asset growth in markets. For this reason, the trader/speculator is playing a ‘zero sum game’. His gain must be someone else’s loss. In fact, due to transaction costs (dealing costs, stamp duty, etc.), the trader or speculator is playing a negative sum game.
Figure 2.1: Speculating vs Investing
Figure 2.1 makes a distinction between the activities of the speculator and those of the investor. If you find that you have been trading too often, introducing charting, technical analysis and options trading, without having the necessary experience – and few private investors have – the chances are high that you are engaged in speculative, rather than investment, activity. Most likely you are also getting a speculator’s results, perhaps without fully understanding why.
OBTAINING POOR VALUE
In the US stock market, shares have been valued, on average, at 14 times historic earnings over the long-term. At this valuation level, the US stock market on average has delivered returns of 9% to 10% (before investors’ transaction costs). If you pay substantially higher multiples of earnings for the US stock market, then you run the risk of much lower returns than the 9% to 10% that historically have been delivered. For example, in the late 1990s, investors were paying over 30 times the historic earnings of the S&P 500 Index. This fact goes a significant way to explaining why returns from the US stock market have been poor since. So value matters and the same argument applies to individual companies, property investing or, indeed, investing in any asset. Yet, investors often suffer from the herd instinct and buy into the most recent popular investment areas without realising that, as a result of this popularity, value is most likely to be absent.
MISTAKING A TEMPORARY LOSS FOR A PERMANENT LOSS
Without a strategy, it is all too easy to sell because markets are declining, the news flow is poor and you lose confidence. But declines in markets are normal and rarely lead to a permanent diminution of value. For example, the US equity market declined by over 50% in the 2007-2009 global credit crisis-driven bear market. During the same downturn, the share price of Coca Cola, one of the strongest companies globally, declined close to 40% from $64 in December 2007 to $39 in early March 2009. Yet, Coca Cola’s earnings did not fall, it was never under financial strain and its shares were not overvalued at the start of the crisis (the Coca Cola example is discussed in greater detail in Chapter 8, The Difficulties of Stock Picking). The decline in Coca Cola’s shares over this period was a temporary decline driven by market conditions and not by any signs of deterioration in Coca Cola’s business.
Holders of Coca Cola shares who sold out during the 2007-2009 bear market mistook a temporary decline for a permanent one. In so doing, they converted a temporary loss into a permanent one.
A HAPHAZARD APPROACH TO INVESTING IN INDIVIDUAL STOCKS
Many investors start off in markets by buying a share, but without understanding why they are buying it and without examining what their long-term goals are. Without a plan, you will be prone to range of errors and the following are just a few examples that might resonate with you. The examples relate to buying and selling shares as opposed to funds but the same logic can be applied to fund investing.
Have you bought a share without knowing why?
The explosion of technology stocks in stock markets in the late 1990s saw many investors buying shares in businesses that had existed for only a limited time, about which they knew little and could not value.
Have you bought more of a share that you already owned, simply because it had dropped in price and you wanted to lower your average cost?
Again, this is not a strategy that is likely to work out in the medium-term for the majority of private investors. The danger with this approach is that you end up with a company that simply goes from bad to worse and never recovers. As we now know from the painful banking crash, this can happen. I show in Table 7.3 in Chapter 7, Stock Market and Direct Property Investing that, of the companies that constituted the FT 30 Index in the UK in 1952, only four remain in that index today. While many were simply taken over or merged with other companies, some businesses did fail along the way. More recently, we can point to many banks in the developed world that will never recover fully from the problems they have encountered. Averaging down for the sake of it is not a sensible strategy for stock market investing. Of course, if you can distinguish between a temporary decline in price and the permanent loss of value, you may feel that you can average down in the shares you own. My experience, however, tells me that few private investors are equipped to make that distinction.
Have you bought a share, simply because you heard friends or colleagues talk glowingly about it?
In this instance, you probably had money burning a hole in your pocket and could not wait to get in. During the Internet boom that ended in early 2000, companies like Cisco, Intel, Vodafone and Yahoo! were vastly overvalued and subsequently lost an average of over 90% of their collective value during the 2000-2002 downturn, and not even Vodafone has recovered fully in price over the subsequent 12- year period. Again, reading about the ‘flavour of the month’ in newspapers and taking tips from others is not a strategy for stock market investing.
In Chapter 21, Enhancing Returns: Value Investing in the FTSE 100 Index, I outline a disciplined stock picking strategy for investing in, and most likely out-performing, the UK FTSE 100 Index that is easy-to-follow and implement and overcomes many of the problems investors encounter when faced with the decision as to what shares to buy and when to sell.
This chapter probably is worth re-reading when you have finished the book. Many of the other chapters address these common errors in a variety of ways, and the penny may drop for you following a revisit to this chapter.
3: WHY MARKETS SHOULD RISE OVER TIME
In the main, the stock markets are made up of businesses, financial products and financial instruments quoted on regulated exchanges. A company can obtain a listing on any stock exchange but, as there are costs associated with each separate listing, only the larger companies tend to have multiple listings. For example, many of the larger UK companies are listed on the London Stock Exchange as well as on the New York Stock Exchange. Outside of companies, there are funds, government bonds and a variety of other financial instruments listed and traded on regulated exchanges across the world.
As the banking system is to savings and loans, so the stock market is to investment. People place their money on deposit (or in current accounts) with the banks, which then lend on those deposits to borrowers. In the stock markets, companies raise capital through initial public offerings (IPOs), aimed principally at institutional investors but often also including private investors, while simultaneously listing on to a stock exchange. The company’s shares then are tradable by all investors in what is described as the ‘secondary market’. These same companies can raise further monies from investors through rights issues, share placings and other means. Ultimately, institutional and private investors with capital to invest, and companies who need capital, meet in the marketplace (or the stock market).
A stockbroker is someone who is licensed to deal on the stock exchange, and private investors must deal through a stockbroker to buy and sell shares that are listed on the stock exchanges. It is a highly regulated industry. With the advent of the Internet, there are now low cost, execution-only online brokers as well as higher cost, full-service traditional brokers.
The developed stock markets always have made upward progress over time. It is important to understand why the markets have made this progress, in order to have the confidence that they will continue to do so in the future. Having this confidence is crucial to staying with your stock market assets when you encounter difficult economic conditions that will be reflected in weaker stock markets. Quite simply, we must believe that markets will recover after setbacks. If we doubt this, there is not much point in investing in risk assets of any variety, whether quoted on the stock markets or not.
RETURNS FROM RISK ASSETS MUST BE HIGHER THAN BANK DEPOSITS
People have always traded with each other. From trade, businesses develop, which leads to growth in the economy. It is not the other way around: the economy does not grow without businesses. Returns generated by businesses, in aggregate, always should be higher than bank deposit rates. If this was not so, then few, if any, businessmen would invest in their own businesses, because they would be better off leaving their capital sitting idle in the bank. If everyone did this, there would be no investing – only savings – and interest rates would decline to zero.
This is the reason why stock market returns, in the long-term, always should be higher than bank deposit rates. It is a simple law of economics.
Furthermore, in the stock markets, most companies retain a portion of their earnings to fund further growth. This could be to finance new products or services, or an entry into new markets. Overall, it is this reinvestment of earnings that propels the value of individual companies, and, in turn, the stock markets, higher over time.
BUSINESSES FIRST, THEN PROPERTY
This, then, is the simple explanation both as to why the stock markets generate higher returns than bank deposits over time, and why the markets make good upward progress over time. Indeed, it is also the reason why property markets move upwards over time. But it is business first, then property. For if we do not trade with each other, thus creating business (or businesses), then we will have nothing to invest in property. One might say that we build wealth through business and invest wealth in property.
Of course, the underlying assumption an investor makes is that he is dealing with a market where democracy is the order of the day, and where the government is pro-business. Markets in more politically unstable areas of the world have not necessarily delivered returns greater than risk-free cash deposits.
STOCK MARKET INDICES
The progress of the stock markets is tracked through stock market indices. Different indices have been developed to track different markets.
The oldest index in the world is the Dow Jones Industrial Average, otherwise known as the DOW, comprising 30 large US companies by market capitalisation from a broad selection of sectors across the US economy. The DOW Index tracks the average performance of these stocks. Similarly, the S&P 500 Index tracks the performance of the 500 leading companies in the US market.
In the UK, the most widely followed index is the FTSE 100 Index, which tracks the performance of the 100 largest companies by market capitalisation quoted on the UK stock market. In Ireland, we have the ISEQ Index, which tracks the average performance of all the companies listed on the Irish Stock Exchange.
And there are ‘World Equity’ indices, such as the MSCI World Index or the FTSE World Index, which track the performance of a large selection of companies from many different markets, in order to provide a guide on the progress of global markets.
Chart 3.1 displays the S&P 500 Index since early 1966. This index measures the progress of the top 500 US companies by market capitalisation across a wide spread of sectors or industries. The vertical left-hand scale represents the index, which started at 50 in 1957. The scale is a semi-log: the distance from 10 to 100 is the same as for 100 to 1,000 – each is a multiple of 10. Using a semi-log scale more accurately represents the percentage (or proportional) movements over time. This is not possible with traditional linear charts.
Chart 3.1: S&P 500 Index (1966-2011)
Source: GillenMarkets.
There are two main messages that can be taken from the chart. The first is that the returns from this basket of stocks have been 9.4% compound per annum since 1966, including dividends reinvested. The second is that the journey was volatile. From 1966 to 2011 inclusive, 11 years delivered a negative return, while 35 years generated a positive return, again including dividends.
The chart highlights that the US stock market went nowhere from 1966 to 1981. Substantial progress was made during the 1980s and 1990s. The US and most developed markets peaked in 1999, and have made no progress over the following 12-year period, a performance that is reminiscent of the 1966 to 1981 15-year period.