Money: Keep holding on ... and on : THE LATEST NEWS FROM THE MOTLEY FOOL

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The Independent Online
HAVE you sat down and really thought about how the stock market works? People who have been following this column for a while know that the Foolish philosophy is all about buying and holding shares in good companies. And by holding we don't just mean six months or a year. We're talking three, five, 10 years, and more.

Anne Scheiber, a humble New Yorker, died in 1995 leaving a fortune of more than $20m to charity. This fortune accumulated from an initial investment of $5,000 in 1944, and was made entirely from investing in the stock market. She bought shares in great companies like Coca-Cola and Gillette, and then just sat on them. And sat, and sat, and sat.

Abbey National, synonymous with the term "windfall", is a classic example of the sort of wealth you can accumulate by investing in a household-name company. Abbey is now a bank, having left its mutual building society roots long behind, but banks are hardly known as your typical growth company. The mortgage market is extremely competitive, with lots of different players offering a wide range of products.

Five years ago, you could have bought shares in Abbey at 485p. Six months later, you may have been a little worried as the shares had steadily fallen to 388p - a 20 per cent loss in the space of a few months is not supposed to be in the script. In fact, it took the shares over a year just to get back to the price you'd paid for them.

During that dim and dark first year, your faith in the company and the stock market was probably tested. When the shares were falling, you felt you were losing money. Worse, you didn't know when the bottom was going come. Your 20 per cent losses could conceivably turn into 40 per cent and more. In the worst case scenario, you could lose your whole investment. The temptation to sell out was great (not being able to handle the paper losses) and cap your losses. No one likes losing money, and it is not a nice feeling. However, although they didn't know it at the time, good news was just around the corner for Abbey National shareholders.

From the low point of 388p, the Abbey share price never looked back again. A year after your purchase, the shares finally got back to the 485p you paid for them. That moment would have been greeted with some relief, because many people can't bear to ever sell a share at a loss. As of today, the shares hover around the 1,300p mark, meaning that your initial investment has appreciated by about 170 per cent. To put that into some context, that's the equivalent of compounding annual returns of 21.8 per cent. If you had left your money in the Abbey rather than buying shares in it, you'd have earned compounded annual returns of about 7 per cent. Quite a difference. And the Abbey return doesn't include dividends, which have grown at an average rate of 20 per cent per annum over that period.

Shell is one of the very biggest companies in the world, and a household name. Yet the company and its share price have been going through a rough patch. The share price peaked at 485p in October 1997, and now hovers around the 400p mark. Shell has been struggling to generate a decent return on its assets, and the oil price has been in the doldrums for well over a year. Yet if you'd bought the shares five years ago, and held them all the way through to now, you'd have achieved a 12.1 per cent compounded annual growth rate, again not including dividends. That is way above the returns you get from a bank account, and almost bang in line with the returns the London market has generated annually over the past 80 years.

You should see from these examples why we Fools advocate long-term buying and holding of shares. We're not talking about any old companies either, because many destroy value over a period of time. Those are usually companies with poor management, operating in extremely competitive industries, and not generating high returns on their assets. You should look to invest in quality companies - with the opposite characteristics to those we have listed above.

World stock markets are at all-time high levels, and this has been highlighted last week by the Dow Jones breaking the psychological 10,000 barrier. Now, more than ever, the time factor is critical. The value of compounding returns really comes into its own as the years roll by. Long-term stock market investors should never forget that.

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On starting work in 1988 I decided to buy a house and let a room in it, rather than contribute to somebody else's mortgage. I also saw a chance to make some capital gain as the property boom had not yet reached the area. I paid pounds 15,250 for the house and sold it nine months later for pounds 33,000 on leaving the area. Had I rented, my profit would have been zero.


The Fool responds: The housing market is hard to time, but you seem to have done it successfully. A property investment is like buying shares - over time its value will appreciate. But the speed of your rise was probably not the norm.


Can you explain what a "stop loss" trigger is in the context of equity investments, and how it might work?

AM, London

Some people set stop losses for their investments, saying that if the share price falls below that level, they will sell. The theory goes that you can cap your losses at a certain level, say 20 per cent below your original purchase price. This arbitrary limit supposedly imposes a discipline on you.

That's the theory. In practice, such as when a company issues a shock profit warning, the share price will immediately halve. Unfortunately, the share price doesn't conveniently stop at 20 per cent when it's on its way down so you can sell at your stop-loss level. Also, as you will see from the Abbey National example above, you may be selling shares in a perfectly sound company, missing out on the years of upside. So by all means use stop-loss triggers, but consider the pitfalls.

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