“The stock market is a device for transferring money from the impatient to the patient” – Warren Buffet
I could not agree more with the above statement if you want to earn money from the stock market it has to be for the long term. Over the years the S and P 500 has averaged 10% return since its inception in 1928, therefore in the long run you are bound to make a return. Despite this when I speak to people about stocks and shares, I get a multitude of different excuses about why people do not invest in the stock market. These excuses fit neatly into three categories:
- My Uncle Alfred tried the stock market once and lost lots of money
- I just don’t get the stock market
- I invest in other things (like bricks and mortar)
Behind these excuses usually lies the real reason people do not invest in the stock market, fear of losing money. The stock market is volatile. What I mean by this is if you look at the price graph for an average share it looks like a series of random peaks and troughs. It is possible that if you invest in a share at a peak and sell in a trough that you will lose money. There I admitted it. However if you invest steadily for the long term (5 years+) as I will explain to you in this article, the risks are much much reduced and you are almost guaranteed to make money.
Introduction to stocks, shares and funds
A share is part ownership of a company, it is as simple as that. Imagine Company A has been cut into a thousand pieces/shares. The shares are now bought by individual investors. You have decided to buy one share in that company and therefor now own 0.1% of that company, simple enough. In general if a company is doing well i.e. making a profit and growing turnover, the share price will go up because the company value will go up. Of course the latter is also true, therefore before investing in a share it makes sense to make sure that the underlying company is projected to do well in the future. This is called due diligence.
Companies that have been floated on the stock market are called Publicly Listed Companies or PLC for short. This is because they have been listed on the stock market. These companies come in different sizes and be broken into:
- Large Capitalization companies – Usually companies worth more than £3.5 billion
- Medium Capitalization companies – Usually companies worth between £1-3.5 billion
- Small Capitalization companies – Usually companies worth less than £1 billion
To calculate the market capitalization of a company it is the number of shares multiplied by the price of the shares. Simples.
A fund is a group of shares lumped together under one banner. Funds come in two different forms: Active and passive funds. An active fund is one that is controlled by a fund manager. The fund manager is hopefully a super clever chap that is paid to outperform the average. A passive fund is controlled by a computer. The computer performs the tasks that it has been programmed to do.
Why I no longer pick individual stocks and shares
Correctly picking individual stocks and shares is a full time affair. To pick the correct share is not as simple as reading a copy of money week and copying what the “Professionals” are doing. This is because 86% of active funds failed to beat the market in 2014. These are controlled by fund managers that went to university, have studied finance all their life and do it full time. What is the likeliness that you will beat the stock market when you are starting out? Slim to none.
For the same reason I no longer invest in active funds. Active funds have the problem that they need to charge their investors for the “fund managers”. This is usually in the form of an initial charge and an ongoing charges. Initial charges of 3% are not uncommon in active funds and on top of that there may be a 2% on going charge. These charges automatically make the fund managers job of beating the stock market difficult. They are starting out at a large disadvantage of around 5% in the first year. Yes some fund managers do massively outperform the stock market even with this disadvantage (Names such as Warren Buffet and Neil Woodford spring to mind). They are definitely in the minority.
What I do instead
I invest in passive index tracker funds. These funds as the name suggest track an index. This could be the S and P 500, the FTSE100 or any index imaginable. The reason I do this is because I am playing for the average 10% return that the stock markets have historically produced. Why would you only play for “10%” you may wonder. A simple play around with a compound interest calculator reveals that investing £1000 a month over 30 years at a 10% interest rate would make you £2.2 million. You would be a multi millionaire from saving £1000 a month.
“Sometimes the smallest things take up the most room in your heart” – Winnie the Pooh (or in this case your pocket)
- Passive funds tend to outperform active funds over the long term
- Companies have different Market capitalization based on size
- A fund is a group of shares
- Invest for the Long term
In part 2 we will be covering pound cost averaging and how to chose the right passive fund.