Looking through the paper, I see two similar sized houses for sale, one for €140,000 and another for €200,000. Which is better value? Looking solely at price, the obvious choice is the former, but, on closer examination, I find that the latter is better maintained and is located close to shops, schools etc while the former is in a run down area. The point is, there is a reason for the difference in price.
It is the same with stocks. If a stock appears too cheap or expensive, there is usually a reason. For example, if you are comparing two pharmaceutical stocks – Company A, which is valued at ten times earnings and Company B, which is valued at fifteen times earnings. From a purely valuation perspective, Company A looks the more attractive, but, if you carry out further research, you will probably find that Company A has only average prospects. It may have certain key drugs approaching their patent expiry dates. On the other hand, Company B may have a promising portfolio of drugs ready to come to market, which should boost its profitability.
In reality, selecting winning stocks is difficult, as the market price generally reflects the stock’s prospects. To be successful, you need to be smarter than the market. But over 80 per cent of professional and private investors fail to match the market. So, if you cannot beat the market, why not be the market. How can you do this?
Index trackers or exchange traded funds (ETFs) are the way to go, as these seek to replicate the performance of an index or market. For example, an ETF, which follows the FTSE 100 Index ( the UK market), achieves this by investing in the 100 stocks making up the FTSE and mirroring any subsequent changes in the Index. Therefore , if BP and Tesco account for four per cent and two per cent by market value respectively of the index, the ETF will invest four per cent of its funds in BP and two per cent in Tesco. If BP then rises in price to represent five per cent of the index, while Tesco falls to 1.5 per cent, the ETF will purchase more BP stock to bring its holding up to five per cent and sell Tesco stock to reduce its holding to 1.5 per cent.
In addition to improving performance, ETFs reduce risk by providing exposure to a basket of companies, which is particularly useful when the risk and volatility associated with individual stocks is elevated. For example, during the banking crisis of 2008 to 2010, any investor investing in an individual bank stock would have been taking a significant risk given the uncertainty regarding bank solvency that prevailed. An investor believing that banks were good value, rather than taking a risk on one individual bank, could have invested in a banking ETF that had holdings in all the major international banks. Going the ETF route removes the risk that you invest in the wrong bank and, if you are correct about the banking sector, you will benefit.
A simple ETF based approach