The Index Fudge

It is amazing that we all spend so much time talking about 'the market'. That's fine for someone who has their money buried in a managed fund invested in 'the market' but for the average 10-20 stock direct investor or trader the market and the Australian indices that represent the market are an almost complete irrelevance. Here's why:

• For one, you are not invested in 'the market' you are invested in ten to twenty specific stocks. That's what the stock market is all about, which stocks you hold and what they are doing. That's what will determine your return and this is where you should focus your attention and efforts. Not 'the (whole) market'. Why look at that?
• Amazingly 50% of the market index in Australia is represented by the 20 biggest stocks and 80% by just 50 stocks. The index is hardly representative of all 1900 stocks. If you are not invested in BHP, the four banks, Telstra, Wesfarmers, Woolworths, RIO or Woodside then 50% of the index calculation is irrelevant to you.
• The Australian market is dominated by three almost entirely independent sectors; financials, resources and industrials. Mixing them all up together in one index quote doesn't tell you much. You have to look at them individually to know what's going on and to make decisions on stock trends. For instance, although everyone thinks the market peaked in November 2007 the truth is that the resources sector didn't peak for another six months. If you had made a decision on all your stocks based on your (or CNBC's) assessment of 'the market' you would have missed the fact that the resources were still going up whilst the financials were going into a sub-prime spiral.
• The index is a tool used by big institutions to generate average market returns which are then used in financial product marketing as a basis for quoting expected future returns. But the truth is that the average market returns in the past bear absolutely no relation to how the market is going to perform in the future. The average return from the All Ords over the last 75 years is 5.76% but laughably not one 12 month period has actually returned 5.76% and the dispersion of returns is enormous with the highest return at 86.1% and the lowest at -41.7%. In the next 1, 5, 10 or 20 years you are going to experience your own unique set of returns and they will bear no relation to 5.76%, to the past. Average returns are a marketing tool, a lie designed to make you feel comfortable so that you will buy something and anyone pedaling past returns as a justification for making future investments is either ignorant, lazy or selling you something. Past returns as a guide to the future, especially in the current turmoil, is the elephant in the room when it comes to stock market lies. They are irrelevant at best and a deception at worst. When a product says past performance is no guarantee of future returns, it's not a disclaimer, it's a fact.
• Even if the index returns did repeat in the future you are not going to make money out of 'the market'. 5.76% less inflation is not much. The government says inflation is 2-3% but the long term average is more like 4.7% and the truth is that we all have our own unique inflation rate depending on what we spend our money on. If you eat, drive, pay school fees or eat bananas it's higher than 4.7%. Headline inflation is politics not statistics. But even if you take off the current 3.6% it means you are dealing with an historic average real return from 'the market' of 2.16% and if you then take off dealing costs, tax, management fees if you are in a managed fund, financial planner fees if you used one to buy your managed fund, the associated product trails, and the index fudge you can see that the market is a lot of fuss about nothing. If it wasn't for dividends, which most people don't compound and retirees almost certainly spend, there wouldn't be much point investing for the average return. Basically you have to do better which means being in the right stocks at the right time, not all the time.

'The market' is the tool of commentators, the media, product sellers and the fund managers who use it as a benchmark. But you have no benchmark. It's far better for you to forget the market and deal with 'stocks' and the stocks that you hold. That's the game.

Marcus Padley is a stockbroker with Patersons Securities and the author of stockmarket newsletter Marcus Today. For a free trial go to marcustoday.com.au - His views do not necessarily reflect the views of Patersons.