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The Torygraph, pondering the sorry state of the FTSE 100 index as compared with itself in the heady days of the dot-com boom, regretted that it was hard to see how you could make money when the market is trading sideways.
At first I was somewhat nonplussed. From my current experience, it seems obvious – find yourself companies making useful stuff. Then chase income, young man
It highlights a more general problem with stock market investing as it is often thought of now. Way back in those heady dot-com days, I was a highly active trader, burning my way through scads of cash. Because I saved as I was working to ‘invest’ I never got into trouble, but I recently had a clearout. I had an A4 folder marked shares, which was chock full of contract notes from that time.
Even if I was capable of not losing on the turn, which I most definitely wasn’t, each purchase and the matching sell pair of contract notes added up to about £20 in dealing costs ISTR. Charles Schwab did very well during that time, and I really should have taken more holidays or perhaps bought more hi-fi or camera gear instead of ‘investing’.
Ah, buying individual shares was my problem, what I should have done was buy the index. Fortunately, Virgin Finance came along with an index-tracking
FTSE100 (no they didn’t see footnote) ISA that adhered to CAT standards with a TER of 1% (which was good at the time). So I bought some of that. Fast forward six or seven years, and I needed to recover the cash. I had sold out of the Virgin ISA at a slight loss over five years and transferred to a Legal and General ISA which offered a selection of funds including the FTSE 100 – I moved because Virgin’s fees were starting to look high. And every year they told me my ISA had gone roughly nowhere, or it had dropped. I never took money out of these ISAs until liquidation, dividends were reinvested while holding.
So I have had two prior experiences of stock market investing. One was quite clear, don’t chase momentum (buy what’s going up, is in the news and all your mates are buying), and if you really have to do that because you can’t help yourself then for God’s sake don’t trade endlessly searching for the Next Best Thing. Don’t do that.
However, from my second experience, index investing didn’t work for me in the UK market, at least over the last 10 years. If somebody asked me how to approach the stock market, I would probably point them at that article and say it’s hard to argue with the logic, though I’d have to ‘fess up that I don’t do that myself, and suggest they take the time out to study the subject more. I am all for people of sound mind applying intelligence to getting to the goals they want to achieve. Driving a brokerage account without having some understanding of the theory and principles just strikes me as unwise – and it was in my case the first time round.
I also observe that Monevator himself swims in the deeper waters outside the index shallows. Some of those are way too deep for me, but I have picked up a fair amount of knowledge from that blog which I have turned to my advantage once I have understood them. And no, I’m not going to blame you, mate, if it all goes pear shaped – my mistakes are my own. And it all going pear shaped is also a serious possibility in my world-view anyway.
However, when I review the articles I have learned from and applied, none of them are the index investing parts. And that’s because I don’t believe index investing works properly any more. That has certainly been my experience over the years 2001-2007, and my L&G ISA was mainly lifted by non-UK funds, which was pure luck as I sought to diversify a bit. That lift compensated for the losses I took on the FTSE100, it was a confirmation of the value of diversification rather than a great success.
So what is wrong with index investing for me?
- It’s not great at paying income – it is a combination growth/income play, with in increasing tendency towards accumulation shares (which turn dividends into effective growth). For most people there’s nothing wrong in that but it doesn’t suit my needs for income
- Too many people are doing it. I suspect that the huge index investing inflows, and the ‘closet tracker’ active funds are beginning to distort the investment market.
- Increasing consolidation and loss of diversity in the FTSE 100 – it was all about tech in the tech boom, it was all about finance, now a third of the market is in oil and mining.
- It didn’t work for me – twice, over a period spanning 10 years! (I’ve switched approach for the last 3 years but it would’t have come good till now)
The third point, the focus on the current sector de jour, is I think a serious issue. Perhaps the FTSE100 is chasing momentum by sector.
There are things you can do to address this. Here is a series on how you can take an analytical approach to spreading the risk using multiple index funds, and RIT has a wealth of information on how to take the subjectivity out of index investing. RIT, for what it’s worth, has battle tested his investment strategy and it held up. That kind of validation means his approach deserves serious consideration. You can’t argue against track record.
So what’s so damn special about me then? Part of it is that I was convinced by a couple of Warren Buffett’s maxims. One was don’t buy what you don’t understand, the other is buy and hold like the market will be closed after you’ve bought – for 10 years. Something like that, anyway. Let’s take these two.
Buy what you can understand.
Obviously as a layman I am not going to have an detailed analytical knowledge of the field of operation of a lot of companies, even the ones I’ve worked in. However, I can understand what Shell, Vodafone, AstraZeneca or pretty much any of the companies in Monevator’s High Yield Portfolio do. They are mostly real companies and they do real stuff – they dig stuff out of the ground or enable businesses and people to communicate. There are some airy fairy hard to pin down companies. What does Aberdeen Asset Management really do, where is the wealth created, in AAM or in the companies they own? Generally, the principle of buy what you can understand seems to shorten the chain between you the buyer and the action on the ground. I don’t do hedge funds, I don’t do China, and all sorts of good stuff, because I don’t understand it
So how does a FTSE100 index fund make wealth? Beats the hell out of me, it was a surprise to me that 30% of the index was commodities, mining and oilies. Not so long ago it was financials. Even if I get a list of the FTSE100 components and I work my way through them, I still can’t say what I am buying if I buy an index, because it changes with time, and to some extent it chases momentum, as the FTSE100 effectively buys success. I don’t know whether that’s good or not, you’d have to take a snapshot of it an backtrack to see if you kept the components fixed whether the swapping in and out of the index adds or subtracts value or is neutral. Chasing momentum wasn’t good when I did it in the dotcom bust.
Index investing may work better in the United States, where a common index is the S&P 500, which presumably has a lot less churn of the biggies, because there are 400 more slots for a company having a hard time to drop through, so the churn is presumably at minnow level. This objection might be mitigated by going towards the FTSE350, which seems to be the FTSE100 + the FTSE 250, again forcing the churn at the bottom end to be at minnow rather than shark level.
Buy and hold like the market will be closed for the next 10 years
Buffett himself described a fundamental truth in a recent interview.
So there’s two types of assets to buy. One is where the asset itself delivers a return to you, such as, you know, rental properties, stocks, a farm. And then there’s assets that you buy where you hope somebody else pays you more later on, but the asset itself doesn’t produce anything. And those are two different games. I regard the second game as speculation. Now there’s nothing immoral or illegal or fattening about speculation, but it is an entirely different game to buy a lump of something and hope that somebody else pays you more for that lump two years from now than it is to buy something you expect to produce income for you over time. I bought a farm 30 years ago, not far from here. I’ve never had a quote on it since. What I do is I look at what it produces every year, and it produces a very satisfactory amount relative to what I paid for it.
If they closed the stock market for 10 years and we owned Coca-Cola and Wells Fargo and some other businesses, it wouldn’t bother me because I’m looking at what the business produces. If I buy a McDonald’s stand, I don’t get a quote on it every day. I look at how my business is every day. So those are the kind of assets I like to own, something that actually is going to deliver, and hopefully deliver to meet my expectations over time.
It’s not the first time he’s said it. And slowly, I have come to the conclusion the old devil has a point. I came to it via a different route to WB because unlike him I do not believe in the myth of continuous growth, and I believe there are natural limits to economic activity.
The myth of continuous growth is deeply built into the assumptions of index investing, albeit indirectly. And I believe that assumption is flawed, and that it will fail at some point when economic activity outstrips enough of its inputs. Yes, we have an infinite supply of human ingenuity. But we don’t have infinite supplies of other raw materials, and indeed some are running short. That doesn’t necessarily make me a doomsdayer; for the vast majority of human history we have had an economy which was pretty close to steady-state. The stock market was created before the Oil Age, and worked acceptably, even suffered booms and busts like Tulipmania and South Sea Bubble, showing the same pathologies as today.
In that clip Buffet has also identified the sorts of companies from which you will still be able to turn a profit in a steady-state economy. This extract is of course not his entire philosophy, he can spot growth opportunties too. A steady-state economy isn’t a static one – sectors will still bloom and wither between themselves, and there may well be a gradual slow progress as that much vaunted human ingenuity uses the limited resources in smarter or more efficient ways. But the index investing paradigm will be damaged, because stock market performance will become more of a zero-sum game. At the moment we can turn the gift of fossil energy into embodied capital wealth. You could argue we might want to distribute it less unevenly, but that free energy has been pouring into the economic system, and index investing is in theory a reasonably efficient way of taking a share in some of that wealth increase. If it is starting to break down then it may be telling us something, possibly about Peak Oil from another angle 😉 Or it just may be a statistical blip, you can only make these calls from a distance, which is a drag if you are investing for the future.
The Coffee Can portfolio
One area I will be different from many investors is I aim to go towards a coffee can portfolio, (original reference here, first page free, paywall for more) as well as favouring income. As a policy, I will try and avoid selling for investment purposes. Whether I have the nuts to stick with that remains to be shown, but I am getting better at it. It is particularly hard when you only have a couple of stocks in your portfolio, since you risk being killed off by a company going down. I have enough diversity in my portfolio now to tolerate that risk, with six companies, an investment trust, an emerging market ETF and one fixed-interest component. No one or two companies going bust will kill my ISA off. I will continue to add to it, focusing on income, rather than growth. I had no talent for spotting growth in any consistent manner but I can see a steady income stream. Of course the latter is subject to stuff like BP’s fiasco last year but a good track record is hard to fudge. So I’m just not going to chase growth any more. After more than 10 years (27 if you count my buying BT shares on flotation with a stake of £300 borrowed from my Dad) of stock market investing I have come to know what I don’t know.
A coffee can portfolio, with a policy of not selling, is madness if you are seeking growth. The only way you get ahead with growth is to buy low and sell high, then hopefully rinse and repeat. The selling decision is, however, another opportunity for error. I am going to make a conscious effort to hold on to companies once I’ve come to the conclusion they have a decent track record of providing income, or those that have had a good track record and have fallen on hard times I feel will end. Last year I bought BP after their Macondo mess and churned it before selling out on a dip. I should have held it – over the coming years it will probably more than return to what I had paid for it. Even in their darkest hour the fiasco wasn’t a huge part of their business. Hopefully that was my last lesson on that subject.
So far, once I switched to seeking income, I have not sold any of my holdings, merely added to them, keeping a watch on my diversification by sector. These companies are still working for me, bringing me dividends. It so happens that at the moment the aggregate value is some 8% up on purchase, but I need to learn to ignore that, though I will need to monitor the income. Because the income from my ISA portfolio will only form a discretionary part of my income post retirement, I need to spend less in lean years like 2007 presumably was, or try and smooth the income; this was part of my desire to use investment trusts to do this but I don’t buy them at a premium.
Stock picking is part of the coffee can portfolio. My selection is already skewed by favouring income, and by having criteria for the dividend repeatability, asset allocation and the yield. I will try and compensate for asset allocation shifts with new purchases. Not selling also achieves some discipline – if I have ~£10000 to put in an ISA a year, and invest in lumps of £3000 for strategic high-yield holdings and £1000 for more risky purchases then I’m only going to be adding four to six holdings a year, giving me time to think them over.
Once I have achieved my income target, I may add a FTSE 250 ETF, to try and capture some growth, on the principle that it can’t do any worse than me stock-picking for growth
From my income chasing approach I’ll already have quite a few of the FTSE100 constituents quite heavily weighted, so I don’t need more exposure to the FTSE100.
I’m still an accidental index investor despite this due to AVCs
For all my downer on index investment in this piece, my AVC holdings are FTSE:Global 50:50 index funds so the majority of my shareholdings are index funds 😉 I am saving more in AVCs than my ISA because of the boost given by Mr G Osborne stealing less of my salary, so I can afford to be wrong about index investing and still come up for air.
There may be solutions to make index investing work better
There are other approaches to avoiding the issues I experienced with index investing. RIT’s Building a Low Charge Investment Portfolio and The Accumulator both deal with the topic in different ways – RIT’s ventures towards a mechanical system look to me like they are a way of selecting market timing by valuation, and market timing is something else I don’t have a huge talent for either. I am lucky in starting in the bear market of 2008/9, so market timing is on my side, and I will use some of RIT’s principles to inform me as to what good value may look like.
It is also more specifically FTSE100 index investing that I don’t like, because of its high churn and sectoral imbalance. The Accumulator could help me address that analytically, but fundamentally index investment bores me, I can’t rustle up any passion for it because I can’t understand or know what I am buying. And 10 years of going nowhere with the FTSE100 has given me a jaundiced view. It is a shame that the FTSE100 index is what most people think of in index investing in the UK, Americans have a better deal with the broader S&P500.
Whatever the reason, one thing I do know is that index investing didn’t work for me, over a ten-year period, and indeed two subsets of that 10 years too. My approach therefore combines the high yield portfolio for picking, where I accept lower growth for yield. and the coffee can/Warrren Buffett approach to holding. I figure this meets my need for income and my beliefs that growth is living on borrowed time… I suspect that this current period may be a local maximum in terms of yield – companies have been cost-cutting madly, but there’s only so far that can go before they will actually have to go and increase turnover to keep profits up. If I screw up, well, the AVCs index stuff will save my tail hopefully.
Finally, this part of Buffet’s quote
If I buy a McDonald’s stand, I don’t get a quote on it every day. I look at how my business is every day. So those are the kind of assets I like to own.
reminded me of my multimedia business on the side, and indeed other businesses I am connected with personally. I didn’t need to continuously revalue the company, indeed, it is very hard to value a company whose output is purely intellectual, in the form of rearraged bits on a screen. I didn’t need to. Intuit’s Quicken software told me all I needed to know – I was billing customers more than my costs, result happiness. Why should I use a different way of evaluating the performance of businesses I own to those I hold shares in?
Index investing is touted as a panacea to the issues of stock-picking and when to buy and sell. However, it is all to easy to take the obvious choice, the FTSE100, and stop there. The FTSE100 is not a totally passive investment, though it could be regarded as a mechanical approach to stock selection by objective criteria. Objective criteria don’t have to be desirable.
Index investment isn’t an alternative to thinking about what you are buying, and why, and how it squares with your view of the economic future. Had I engaged brain I might have seen that I wasn’t ‘buying the index’. I was buying a most peculiar part of it, on the assumption that it was a proxy for ‘the stock market’.
If I am going to have to think, I might as well think properly about my aims and beliefs, and invest accordingly. I’d much rather screw up because my world-view was wrong than because I casually switched my brain into neutral after the dot-com debacle and went with the index investment mantra flow.
* I’ve had a search back in that file of share documentation, and the Virgin ISA was a FTSE All-Share Tracker which somewhat weakens the argument that the issue was due to chasing momentum and sectoral allocation shifts. Such is the fallibility of memory – it appears I thought harder about things then than I recall back