Why investing beginners should consider stock marketsPosted: 2017-05-29
I am fortunate to know a lot of smart people. Many of these smart people are successful, and make decent money. Many of those have significant positive net worth. But a surprising amount of them – I would guess over half – don’t choose to invest in publicly quoted equities. They are investing novices, and proud to admit it. This blog post is for them, and their friends/family.
Imagine you are under 50, and have £1k to add to your savings. I don’t mean in your pension, which I think most people handle differently to savings. I mean ‘put aside’ but retrievable on a rainy day / for a house deposit / for school fees / similar.
Where would you put your next 1k of savings? Or more to the point, £10k of savings? Or £50k of savings?
If I were to suggest so my investing novice friends “have you thought about the stock market?”, they’d revert with responses such as:
- “I don’t understand stock markets”.
- “I don’t want to risk losing money”.
- “I don’t like gambling”.
- “I don’t have time to invest in stock markets / pick companies”.
- “I know I should but I haven’t got around to it”.
So, instead of investing in the stock market these guys most likely will have the cash sitting in a lump somewhere.
What return is this ‘cash lump’ making? It delivers an interest rate of, say, 2%. Does it increase in value as well? No. So what is the total return, before tax? 2%. What is the total return after tax? That will depend. Assume you have it in a Cash ISA, which means no tax is even reportable – you’ll end up with 2%.
Now before we turn to equities, let’s consider a Farm. Imagine it is a good, mixed arable farm. Imagine that you bought the Farm 20 years ago – but you play no part in running it at all. Your Farm generates produce every year, which is all sold at market prices. It costs something to run – you pay the Farmer and his(/her) team to run it for you – but makes a profit after these costs every year – more in some years than others. Each year you get an annual report from the Farmer along with a share of profits.
Imagine that you tell your tenant Farmer to pay you, every year, half of the profits that (s)he has made. And you ask your Farmer to reinvest the other half of those profits in expanding the farm. Sometimes your Farmer buys adjacent land. Sometimes your Farmer invests in machinery. Sometimes your Farmer invests in fancy packaging – (s)he’s even considering setting up a website. So your Farm actually grows every year – not necessarily in a smooth line, but looking back over 20 years you can see that the Farm’s business has almost doubled in size since you bought it.
Putting numbers on this example, imagine you’d paid £1m for your Farm. And imagine it’s delivered 7% profits after costs every year. You’ve received half of these profits; initially this was £35k per year but now it’s over £60k per year. But your Farmer has reinvested the other half of the profits every year in expanding the farm. The farm is bigger than it was, has better buildings and more machinery. It is now worth, so you reliably understand, almost £2m. And it makes almost £140k profits per year. This is still a 7% return on the assets, and you’re still receiving half of them, but your total return has been a combination of cash profits plus a gain in the value of your Farm.
Of course your Farm may have bad years. When Mad Cow disease was rife would not have been a good time to sell the farm. With the rise of organic farming, for which your Farm is well positioned, you are on a roll. But these fads come and go and over 20 years the individual ups/downs are not material.
Now consider stock market equities. Let’s start with the FTSE-100 market – the top 100 UK listed companies. These 100 companies are equivalent to 100 farms. Some of them are better than others, but on average these 100 companies do the following:
- Earn around 6-7% of their market value every year as profits, after tax.
- Pay less tax than you would if your money was not in an ISA. Generally they pay less than 20% tax.
- Share about half of these profits with their shareholders as dividends.
- Reinvest the other half of these profits in growth.
In other words, if you bought £1000 of FTSE-100, your holdings would make you about £60-£70, and you’d get about £35 of these profits back to you as dividends. The other £35 would be retained by your holdings and would expand your investment. The next year, all other things being equal, your holding would have gone up by about £35 too to be worth £1035. The idiot press would doubtless be talking about how FTSE has only risen by 3.5%, less than Brexit-y inflation and even your P2P loan; this would be fake news because it would ignore the dividend you’ve had and which you’ve used to buy the fake news-paper. In fact your FTSE-100 investment will consistently make over 5% per year over the long term.
What about your fears and objections to investing in stocks/shares?
First and foremost with the stock market is the perception of risk of losing money. You do risk losing money.
What isn’t often understood is how solid (blue chip) the FTSE-100 is. To be in the FTSE-100 you need to be one of the biggest public companies in the UK. Currently the threshold is around £4bn. One of the smallest FTSE-100 companies today is the Royal Mail – think about that. Over 90% of FTSE-100 is bigger than the Royal Mail. You might not have heard of all of them, particularly those that are not a consumer business or don’t operate in the UK, but you’ve certainly heard of the giants like HSBC, BP, GlaxoSmithKline, BT, Sky, Next, Severn Trent (not to mention Pearson, British Land, Berkeley Group, Prudential etc). Well-known businesses like William Hill, Sports Direct and Dunelm are NOT big enough to be in FTSE-100.
And FTSE-100 companies are well governed. They have experienced management. They have strong brands. They operate in multiple markets. They are very hard to compete with. They are, in short, quality investments.
Of course if a great recession hits and all the FTSE-100 are on the ropes, like what happened in 2008/9, then yes you stand to lose money. But provided you only invest what you can afford to ‘lock up’ for a year or two then your chances of suffering long term losses are much lower than you might think.
You can buy these via one simple investment – for instance Vanguard’s UK Equities tracker VUKE which is tradeable instantly any time the stock market is open. You can open an account within about 10 minutes with a good online broker like Interactive Investor, Hargreaves Lansdowne or Fidelity. Every year over 90% of FTSE-100 make profits. Some may have declining profits, but most of them are growing profits. On average profits grow almost every year.
It’s too complicated? Perhaps. But what’s really the worst that can happen? For the sake of 7% returns, isn’t it worth spending the 30 mins or so it would take to buy £1000 of VUKE, and leaving it alone for a few years?