MARKET COMMENT
A Stock Picker's Market

By Stuart Watson (TMFTiger)
April 8, 2002

With the UK stock market having shown no gains over the last three years or so, we often hear advice like "this is a stock picker's market, the only way to make gains is to frequently buy and sell shares". Whilst there is a little truth to this claim, it's a distortion of the bigger picture.

The performance of the stock market, as represented by an index, reflects the average movements of hundreds of companies. Some will do worse than average, some about the same and some better than average. So, yes, the only way to beat the average is to make a choice and cherry pick part of the market. But can everyone do this? Of course they can't. Just like every motorist thinks they are a better-than-average driver, every investor thinks they can beat the index.

We often bleat on about trackers beating three-quarters of managed funds over the long-term. The same logic extends to the private investor too. The main reason trackers prevail in the long-term over the average fund is lower costs. Trackers typically have annual costs of less than 1%, including trading costs within the fund. However, the costs of a managed fund are typically around 2% and some are even higher. Over the long term, this difference becomes significant in terms of overall return. Few funds will do well enough to overcome this hurdle and beat the tracker. Fewer still will beat the index itself.

Consider a private investor with £10,000 in their portfolio. How likely is it, if they are actively trading, that they will incur costs of £100 or less in a year (i.e. 1%) taking into account commissions, stamp duty and spreads? Most unlikely, I suspect. Say our investor makes 20 trades in a year at £15 a go. That's £300 or 3% of their portfolio's value in costs, even before taking into account stamp duty and spreads. These costs could easily add another £300 in costs, meaning our punter starts with a handicap of 6% in trading costs. That's quite a hurdle to overcome each and every year.

The advice to trade more in a flat market is poor advice for the majority of people. In fact, it's poor advice in any market. Whatever the market conditions, you would still expect only a fraction of people to outperform. And those who trade the most are the most likely to perform the worst. The advice to trade more frequently comes from brokers, i.e. those who will benefit by higher commission levels. That's why even after three years of a flat stock market, we still like trackers. Whatever the stock marker weather, they still provide the best balance of risk and return for the majority of people: those seeking a long-term return significantly greater than that of cash.

More: Get the lowdown on index trackers in our ISA centre 

A version of this article was first published in May 2001.