How to invest in the FTSE 100
Deciding which FTSE 100 stocks to invest in is a contentious topic. Many investors think short-term, and have unrealistic expectations of what level of return to expect
Please note, this post is heavily UK weighted, as I invest in UK stocks and shares and focus primarily on that market. Many of the concepts discussed in this post will also apply to international markets.
Deciding which FTSE 100 stocks to invest in is a contentious topic. Many investors think short-term, and have unrealistic expectations of what level of return to expect from an investment in a FTSE 100 company. Choosing which stocks to invest in is a remarkably simple process, and done well can result in a reasonable level of wealth accumulation over time.
What investing in the stock market is not
Stock market investing, despite what popular investment websites might tell you, is not exciting and not guaranteed to result in life changing returns.
Take this headline from popular investment commentary website Motley Fool;
Forget the National Lottery! This could be an easier way to get rich
-- Motley Fool (20th Jan 2019)
The headline is sensational, and gives the impression to (in)experienced investors that the odds of getting rich investing in the stock market, rather than playing the National Lottery, are somehow significantly higher. This may be true.
It may be possible to make £1 million profit from investing in the FTSE 100. But over what timeframe and what level of investment?
How long does it take to make £1 million investing in the stock market?
How quickly you can become a millionaire through stock market investment depends on how much you can invest annually and your annual rate of return.
Take the following examples;
|Annual Investment Amount||Annual Compounded Return||Years to £1 million|
Historically 8.5% annual compounded return was realistic and achievable. The S&P 500 Index, for example, returned at this level between 2000-2016. But, of course, past performance is not an indicator of future performance.
As the S&P 500 Index, for example, is a market-cap-weighted representation, or generalisation, of the market as a whole, true levels of returns from individual companies can be widely different from the quoted levels. Some companies significantly beat this level, whilst others returned less.
Should I invest in index funds?
Vanguard recently stated that average market returns over the next decade are expected to drop significantly.
While inflation is expected to remain low, investors should expect the nominal rate of return on their investments to be in the range of 3% to 5%, compared with historical averages of 9% to 11%, a panel of Vanguard economists said.
-- Vanguard (26th Jun 2018)
The short answer is, probably, yes, a large percentage of your investment portfolio should be index funds.
Despite lower anticipated (but not guaranteed) returns, investing in index funds is still an attractive proposition.
Assuming the UK rate of inflation remains close to the Bank of England (BoE) target of 2% (expect fluctuations above and below this figure), we can expect above inflation returns of 1-3% over the medium/long term. Whilst less than half the level of returns seen historically, at least your money will still be retaining/gaining value (if at a nominal level) on average over time.
Depending on your risk tolerance, your investment portfolio should consist of at least 50-90% of index funds.
Despite all said, more adventurous investors may be more attracted to investing in specific stocks, because of the possibility of higher returns. Done right, investing in individual stocks can go a long way to accelerating one's rate of wealth accumulation.
Which FTSE 100 stocks should I buy?
Answering this question requires an understanding of what you are trying to achieve.
Our favorite holding period is forever.
-- Warren Buffett
There are generally two kinds of investors;
- Traders: Those looking to buy and sell shares regularly.
- Investors: Those looking to buy shares and hold for long periods of time.
This post specifically focuses on the latter, people who want to own a piece of a quality company for many years to come.
I have dabbled with day trading, very briefly, and found it to be a dangerous game that I never want to get involved in. Day trading is very speculative, and expensive. Trading fees quickly swallow profits, so typically larger amounts of capital are required to realise gains. With greater amounts of capital come unacceptable levels of risk for most people.
In my opinion, the minimum amount of time to invest in a single company is 5 years.
Having this mindset changes the mentality.
Traders desire to make a quick buck. Investors look for quality companies, through comprehensive research, with strong future prospects.
With this mindset shift, understanding which companies to buy becomes a procedural task roughly consisting of the following steps;
Is the company share price, generally, on an upward trend?
Zoom out on the price chart to at least a 5-year view helps to see this clearer. Ignore short term trends.
Is the company paying at least a 5% dividend, and is the dividend rising?
This is a good indicator of a company's financial health, and, of course, will put regular income into your pocket, boosting your overall Return on Investment (ROI).
Does the company have manageable levels of debt?
Debt is a powerful tool, and when utilised well can significantly benefit a business. Company debt should be less than 3x the company's annual profit.
Is the company profitable
For many, investing in an unprofitable company may be acceptable. Personally, I never invest in loss making companies.
Do the company values/products complement your world view?
This may not be important to some, but it matters to me. Do the company values/products align with your ethical and moral standards? For example, if a tobacco company is ticking all the boxes but you fundamentally disagree with the fact that they knowingly sell products that damage health, you might want to avoid making an investment.
All that is left now is to go through each company, check their latest stats/annual reports, look for companies that tick your criteria, then buy and hold.
How to evaluate a company for investment purposes
To determine if a company is ideal for investment, you require the following information;
- The current cost (Bid Price) of a single share
- The bid price of a share from 12 months ago
- The current market capitalisation
- The annual dividend amount
- Current levels of net debt
- Full year pre-tax profit.
All this information for each PLC is available online, from the company's own website, and their latest annual report.
Once you have established these figures, you can drop them into the Share Price Evaluator which will crunch the numbers and identify the quality of the company. Of course, an Excel spreadsheet is also a reasonable alternative.
I personally never consider investing in a company that has less than 3 green ticks. A company with 4 green ticks is rare, but when they come along I will invest 9 times out of 10 with minimal hesitation.
Stock market investment, via index funds or through investing in individual companies, historically, has been an efficient way of making money over time. Index funds are expected to return less over the next decade that the historical average, so investing in individual companies is becoming a more attractive proposition. Determining which companies to invest in is a relatively simple process of understanding the financials of a company, and then assessing the company values/products for correlation with your own. Investing in individual stocks should be a complementary, small slice of your existing (safer) investment strategy.