If you read about investing in the stock market, you'll see all sorts of seemingly meaningless magic words. FTSE 100? What's that? And then there's the FTSE 250, the FTSE Small Cap, the FTSE Fledgling...
But what does it all mean? Well firstly, it's all very well being able to see how individual stocks are doing on a daily, monthly, or annual basis, etc. But that doesn't really tell us how well things are going in the investment world in general. And so the idea of a stock market index was born, which pulls together the valuations of a specified set of companies and provides an aggregate measure of their worth.
The 'FTSE' bit just stands for 'Financial Times Stock Exchange', and that's because the FTSE indexes are maintained by the FTSE Group, which was originally a joint venture of the Financial Times and the London Stock Exchange Group. The FTSE Group is now a wholly owned subsidiary of the London Stock Exchange Group (which is itself a company whose shares you can buy, and is listed on the FTSE 100).
The biggest, and best?
The '100' part just means it covers the 100 biggest public companies listed in London, and that's by market capitalisation. Ooh, another buzz phrase. 'Market capitalisation' just means the total value of the company if you tot up all of its shares at the current market price. As examples, the FTSE 100 currently covers everything from Royal Dutch Shell, valued as I write at £218bn (and incidentally, more than 50% more valuable than the next biggest, HSBC Holdings at £142bn), to Mediclinic International valued at just under £4bn.
Because the Footsie (as it is sometimes whimsically known) is weighted in relation to the size of its constituent companies, every 1% change in the value of, for example, Shell shares will make a bigger difference than a similar 1% change in the value of Mediclinic shares.
So how do you buy into the index and what are you getting? The usual way to go about it is to invest in what's called a tracker fund, and a FTSE 100 tracker just tries to follow the ups and downs of the index. Some funds actually buy shares in all the companies in proportion to their valuation, buy many these days use computer-based strategies that just try to emulate the index's performance. It can be worth checking a fund's tracking error before buying, but most of them are reasonably accurate these days.
One beauty of such funds is that you can typically drip cash into them, with regular modest payments -- it's often possible to invest as little as £20 per month, though more is better if you're sensible with your money. So you can get started with putting some of your savings into top quality shares with very little effort, and no need for any of your own individual company analysis.
And what you're getting for your money is effectively a partial ownership of the UK's biggest companies -- and in many cases, some of the world's biggest.
What do the figures mean?
Now that we know what the FTSE 100 is, what about its valuation? I've had people ask me many times -- its level is currently around 7,600, but 7,600 what? Is that billions of pounds, or something?
It's actually just 7,600 points, and is an arbitrary figure intended to show relative valuations -- and it says nothing at all about the actual values of the companies in the index. The FTSE 100 was launched in January 1984 and was set at a base level of 1,000 points. It's been regularly updated ever since, with a formula that's weighted relative to the valuation of each company.
So when we look at that valuation today of 7,600 points, essentially all that is telling us is that its companies are now worth 7.6 times their overall value on that day back in 1984 -- and that it's however many percent up or down from yesterday, last week, last month, etc.
Bear in mind that it's very much not the same 100 companies that made up the index at inception, as the index is regularly rebalanced as companies rise and fall in value. If, at rebalancing time, the biggest companies in the FTSE 250 (which contains the next 250 by size) are bigger than the smallest in the FTSE 100, we'll see promotions and relegations.
The key question now is, how well would you have done had you invested in the FTSE 100 for the long term? We've seen that since inception in 1984, the value of the index has increased 7.6-fold. So every pound invested in 1984 would now be worth £7.60.
But it actually gets better than that, as you'd have been earning dividends over that 34-year period too. Typically that's been around 3.5% per year over the long term, so you'd have had additional income of around 120% of your original cash -- each pound would have turned into around £8.80. But that's not the end, as you would have done even better if you'd invested your dividends in more shares and enjoyed more of that 7.6-fold appreciation.
UK vs the world
One thing you might have noticed is that you're getting major exposure to worldwide companies if you invest in the FTSE 100. While there are some that are largely UK-focused, like Lloyds Banking Group, plus the utilities companies, and some construction firms, many are not.
To me that means the FTSE 100 should be a safe haven to help protect our savings from Brexit fallout. Whatever the shape of our post-EU deal, an oil giant like Shell really won't care. Nor will HSBC, or pharmaceuticals giants AstraZeneca and GlaxoSmithKline.
But that does raise another question. What should you do if you actually do want to invest more in the UK economy? You could do a lot worse than go for a FTSE 250 index tracker. It contains a higher proportion of UK-focused companies, and it's actually risen around 14-fold over the same 34-year period of the FTSE 100's history.
On the other hand, smaller companies can be more volatile, and the FTSE 250's index yield tends to be lower. Whatever you choose, the secret is long-term regular investing.
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Alan Oscroft owns shares of Lloyds Banking Group. The Motley Fool UK owns shares of and has recommended GlaxoSmithKline. The Motley Fool UK has recommended AstraZeneca, HSBC Holdings, and Lloyds Banking Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.