[Ed Note:The following is an edited extract from a book Vern Gowdie wrote to his three daughters. The book’s title is A Parent’s Gift of Knowledge.]
The Australian share market has two major indices:
The All Ordinaries reflects the share price movements of a larger number of shares.
The ASX 200 index reflects the movement of the top 200 companies in Australia.
The way an index works is relatively simple. The following is an example only and the values I have attributed to each company bear no resemblance to reality.
| Company | Value | % of index |
| CBA | $50 Billion | 14% |
| NAB | $30 Billion | 8% |
| ANZ | $35 Billion | 10% |
| Westpac | $40 Billion | 11% |
| BHP | $60 Billion | 17% |
| Rio Tinto | $40 Billion | 11% |
| Telstra | $25 Billion | 7% |
| Woolworths | $25 Billion | 7% |
| Wesfarmers | $30 Billion | 8% |
| Harvey Norman | $25 Billion | 7% |
| TOTAL | $360 Billion | 100% |
In the above example, if BHP (17%) and CBA (14%) share prices move up or down, the movement influences 31% of the index.
Sometimes when they give the share market news on TV you’ll hear things like, ‘the mining stocks helped lift the index today,’ or ‘banking shares drove the market lower.’ The sheer size of these stocks and their weighting in the index casts a huge shadow over the movement of the share index.
In my opinion the best and most economical way to invest (as opposed to speculate) in the Australian share market is to buy into an index ETF. An index ETF gives investors exposure to a broad range of stocks.
Why invest in the index (Beta investing) and not individual shares (Alpha investing)? With individual shares (buying shares in Telstra, NAB, Woolworths etc.) there are stock-specific risks and rewards. Telstra is a classic example of this.
Telecommunication usage (mobile phones, wireless internet etc.) has grown exponentially over the past decade, yet Telstra’s share price has fallen nearly 50% over the past fourteen years.
The combination of the bursting in the tech bubble euphoria and Government interference to reduce Telstra’s monopoly in the telecommunications sector created uncertainty over the company’s future profitability. And so investors re-priced Telstra’s business.
The banking sector has performed strongly over the past decade. However NAB has been relatively weak due to some poor management decisions. In Jan 2000 the NAB share price was $21.80 and is currently around $30. This is a compound growth return of 2.5% per annum.
Yet BHP, CBA and a handful of other quality companies have performed exceptionally well over the past decade. BHP was around $8 in 2000 and is currently at $37. This is an outstanding 362% return over 13 years. Not bad compared to Telstra losing 50% in value.
Individual shares can be rewarding but picking the right one is difficult and requires painstaking research. For instance, will BHP continue its stellar run for the next ten years or will Telstra be the stand out performer?
History shows this process of consistently anticipating the direction of companies is difficult over the longer term.
Therefore it’s my conclusion that over the longer term you’re better off tracking the index.
The ASX 200 index over the past thirteen years has returned approximately 65%. This isn’t particularly great when compared to BHP or CBA, but significantly better than how Telstra shareholders fared. Investing in the index reduces your reliance on an individual company to perform (alpha) and enables you to participate in the general movement of the market (beta).
The question for stock pickers is, ‘What will be the outstanding companies over the next decade?’ Foresight is a much harder task and it’s for this reason that sticking with the index enables you to participate in the general market movement.
Investing in an index still requires you to do your homework to determine whether the market is over-priced or not. Anyone who invested in the index in late 2007 at 6,700 points has lost 25% of their investment.
In 2007 the market had been in the ascendency for four straight years (2003 to 2007). Common sense and history dictated this trajectory couldn’t possibly last yet the majority of people were lured in by the fact that it had run for that long and believed it would continue.
Using past performance as a future guide is a very poor substitute for detailed analysis. This was another hard lesson to learn for market participants.
When it comes to markets, common sense isn’t so common when greed clouds your judgment.
Vern Gowdie
Editor, Gowdie Family Wealth
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