How to invest in the UK stock market

So you want to invest some of your pension savings into the UK stock market. This post will show you an averagely clever method of doing this. The method is simple and low-maintenance.

There must be smarter ways of investing but, sadly, I do not know them at the moment.

The simplest way of investing in the stock market is to invest in all traded stocks proportional to the market share of each company.

Following the market is not as silly as it sounds. There research saying that in the long run most managed portfolios under perform the market. I believe this. At the same time I also believe that some investment funds do manage the consistently beat the market. I just do not know which ones they are.

What return is normal?

In the last 40 years, the FTSE All Shares Index increased by a factor of 16 which means 1% annually after correcting for inflation (using PRI inflation index) on average. However, there were years when the index lost more than 25% of its value within a year. These bad times were 1988, 2001-2003 and 2008-2009. The biggest year-to-year drop in FTSE All Shares Index was 43% and it was in October 2008. On the bright side, there were also periods of explosions in stock valuations.

Stock appreciation, which is what indices measure, is one way in which you benefit from owning stocks. The other one are dividends.

So how much return can one expect from dividend payments?

It is surprising hard for find good data on historical UK dividend yields. In the absence of an "official" source of this information, I gathered and cross-checked a number of different sites. We have:

• a Bank of England's paper showing average long term historical yields between 3.5% and 4.5%
• a blog about retiring early shows a similar spread in the last 7 years
• a multi-threaded Guardian article quoting the average dividend yield between 1999 and 2013 at 2.1% (but this estimate is too pessimistic because it uses the maximum index value in the denominator)
• a random website showing average market yield between 2003 and 2013 at 3.8% and a similar number for top 100 companies

So the number ranges from 2.1% to 5%. This is already adjusted for inflation. Perhaps we can assume that the dividends are 3% a year on average.

Therefore, in total we have 1% + 3% = 4% above inflation as the average historical stock market return.

How to do it

You can of course buy all the shares quoted on London Stock Exchange in proportion to each company's share of the market. This is theoretically exactly what we want but the admin and transaction cost of owning hundreds or even dozens of shares makes this option totally impractical.

A more sensible option is to buy units of an index tracker. Trackers follow a market index and pay dividends just like holding the actual stocks would.

Some stock index trackers offered by different providers on the London Stock Exchange are:

• Vanguard FTSE 100 (VUKE)
• iShares FTSE 100 (ISF)
• DB X-trackers FTSE 100 (XUKX)
• SPDR FTSE All Share (FTAL)

(I am not recommending that you buy any of the above, I am not a financial advisor, this is just research I found useful for myself.)

How much it costs

At the moment the cheapest tracker to own is Vanguard FTSE 100 (VUKE). Using VUKE as an example, the cost are:

• admin expenses equal 0.1% of your savings annually
• there is a market sell-buy spread, currently 0.13% which you need count in because you will be buying once and ultimately selling once

So, if you own a fixed amount of VUKE for 30 year this will cost you 0.13% + 30 x 0.1% = 3.13% of your final retirement savings. This is 0.1% annually.

It will cost you approximately half that amount if you are starting from zero and will be regularly buying the tracker over the next 30 years. This is because in this scenario, on average over the 30 years you will own half of your final savings.

Over 3% on admin expenses seems a lot. But most pension funds cost way more. I just checked admin expenses of my old pension plan from work and they are 0.35% annually. This means that if I keep this fund for 30 years, it will cost me at least 30 x 0.35% = 10.5% of my final savings.