Here’s what the FTSE 100’s near-record high can teach you about investing

On the last trading day of 1999, the FTSE 100 closed at its highest level ever – 6,930.20.

Yesterday, during trading, it briefly poked its head above that level. But it couldn’t quite hang on, and it slipped back.

Are we heading for a new crash, or are the bad times over? Are we about to put the ghost of the past bear markets to bed?

Any of those things could be true.

But frankly, the price of the FTSE 100 has got nothing to do with any of them.

Why the FTSE 100’s near-record high doesn’t matter

There’s a statistic in the FT today that I found fascinating. In the past two years, the FTSE 100 has ended within 100 points of its record close no less than 42 times. So the index has been plugging away at this record for a long time.

It’s easy to get superstitious about this sort of thing. Does this new high suggest that we’re near another collapse?

There are lots of reasons to be jittery about markets in general – pretty much nothing is cheap, from bonds to most developed stocks – but the FTSE 100 being near an all-time high is not one of them.

For a start, the FTSE 100 stands out as something of an underperformer compared to other developed markets: the Dow Jones and S&P 500 indices in the US have long since left their own dotcom-era highs behind, and even the tech-heavy Nasdaq is getting close to beating its old high.

And you don’t even have to go beyond the UK to see this: the FTSE 250 (the 250 biggest London-listed companies, after those in the FTSE 100) surpassed its own previous record high a good few years ago.

So the fact that one global index is currently having yet another crack at its 15-year-old record high is really not significant. The FTSE 100 isn’t even particularly expensive; it’s hardly cheap, but it’s not at the same sort of valuations it was in 2000.

And there are good reasons the FTSE 100 is struggling. Compared to other indices, it’s packed with the sorts of companies that have had a really hard time in recent years: banks (which may well now be in long-term decline); financials in general; miners (now on the painful end of the commodities cycle); oil majors (a similar story). No wonder it’s struggling.

The two biggest lessons the FTSE 100 can teach you

I think there are two big lessons you can draw as an investor from all the scrutiny on the FTSE 100 as it tries to claw above a level last seen more than 15 years ago.

The first is the importance of reinvesting your dividends. If you’d done that, then even if you’d bought at the peak in 1999, you’d still have made an acceptable return on your investment – even accounting for inflation. That’s the magic of compounding for you.

The second is to have a good understanding of how the index you’re following works. I’m not just talking about having a good grasp of the underlying sectors in the index, I’m talking about the way the index is built in the first place.

You see, things like the FTSE 100 can be useful benchmarks. But when it comes to finding an index you would want to track (say, with a passive fund), there are far more sensible ways to go about it.

The FTSE 100 is just based on market capitalisation, which is ultimately based on share price. The bigger the company gets on this basis, the higher it goes in the index. Basically, it’s a ‘buy high, sell low’ strategy – as a company rises in value (and its market cap goes up) you have to buy more. That’s the opposite of what we’re taught to do as contrarians and value investors.

So if I told you that my fund’s strategy was based on investing solely based on a company’s market cap, you probably wouldn’t be overwhelmed by my investment genius. Yet lots of people are buying passive funds on that basis (or worse still, ‘closet trackers’ that charge you very high fees for doing just this).

However, these days you can buy trackers that still offer relatively low fees, but rather than track a market-cap based index, they use more effective strategies. For example, you can buy funds that track an index that’s based on dividend yields – so you only buy stocks with higher-than-average yields. Or one that’s based on ‘fundamentals’ – value measures that look at the balance sheet, or how cheap a stock is, or both.

One recent launch from Ossiam is based on Robert Shiller’s p/e ratio (you can watch Merryn’s interview with Professor Shiller here for more on this) and invests only in the cheapest sectors in Europe, for example.

Like most other things, this ‘smart beta’ stuff – as it’s known – has a fair share of hype around it and a lot of new launches. But the core ideas are sensible and well worth getting to grips with. You can read more about the subject here.

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