Play patience and you'll have a winning hand

Shares should always score over cash and gilts if you're a long- term investor, writes Steve Lodge

That you get better investment returns from the stock market than the building society over the long term is well known. But how much better? And why?

Over the past 70 years, shares in Britain have given investors an average annual return of 14.4 per cent before tax compared with 5.8 per cent from cash, according to a new study that aims to explain the principles of stock market investment to individuals. Gilts - a "safer" alternative to shares and much recommended by stockbrokers, particularly for investors wanting immediate income - have returned 6.3 per cent, says the Cantrade Compendium of Stockmarket Investment for the Private Investor. Gilts are IOUs issued by the government.

However, for genuine comparisons of these numbers, you should add in tax and inflation. Returns on cash are hit hardest by tax (Tessas apart) because they come in the form of interest which is taxable at your highest rate of income tax. But returns on shares and gilts can consist of both income and a capital gain. Even ignoring PEPs, for many people capital gains are tax-free.

Then add in the effects of inflation - averaging 4.7 per cent over the past 70 years, according to Cantrade - and the argument for shares becomes even stronger. Inflation and tax have killed the spending power of the returns typically earned on cash and gilts. But shares as a whole are still ahead.

Logically, shares must outperform both cash and gilts over a reasonable period - otherwise why would anyone risk their money? Shares can fall in value, even become worthless when companies go bust, and investing in them normally means starting off with a lower income than from either cash or gilts.

In return for providing the core finance of the business, shareholders receive dividends paid out of a company's profits. The remainder of the profits are retained by the company for reinvestment in the business, so building up its assets, earning power and future dividend-paying potential. The value of shares fundamentally comes from this dividend flow. If the pay-outs rise over the years then in general the value of the shares should also rise since the income stream will be more valuable.

Eventually, the worth of a dividend should overtake that of cash or gilts.

Inflation accelerates this process. By and large, companies can absorb the effects of inflation by passing on cost increases to their customers in the form of higher prices, so preserving the profitability of the business.

So generally dividends, and thus the cash-in value of shares, should keep growing with inflation. The value of gilts and savings accounts cannot keep pace in the same way.

The flipside of inflation being relatively good for the performance of shares is that in periods of low inflation - as now - investors should not expect such outperformance, says Cantrade. Furthermore, this hardly seems an ideal time to buy shares with the stock market at all-time highs, interest rates rising, the prospect of a new government, and the possibility of a setback on Wall Street extending to the UK.

But Cantrade's study notes the dangers of cashing in your shares now for fear that they are about to take a big fall in value.

Over the long term the stock market rises, and the periods when it rises can last a long time and be very profitable. History suggests that investors will fear a dozen periods when the stock market falls in value for every one that actually happens, says Cantrade. A long-term investor selling out with a view to reinvesting when prices are lower is taking a bigger risk than simply accepting the ups and downs.

It is worth reiterating that this is not the same as saying that people should switch all their savings into the stock market now. It is not axiomatic that Conservative governments are good for stock markets and Labour governments bad, says Cantrade. There will be bull and bear markets regardless, and it is the global economic environment that matters most.

Equally, though, any sign of a reversion to "old Labour" policies by a new government would likely trigger a sell-off in the stock market. And that could be an opportunity to buy.

q Cantrade is giving free copies of its booklet to the first 100 'Independent on Sunday' readers who call. Phone 0171 614 8051.

The 'Independent on Sunday' also has a free 'Guide to PEPs', written by personal finance editor Steve Lodge. Call 0500 125888 quoting reference 259/1, or complete the coupon.