There is an old stock exchange joke to the effect that a long-term investor is a day trader who got it wrong.

However, on a more serious note, many people find it a useful strategy to be long-term investors deliberately, buying good stocks and then holding them regardless of their price movements from day to day.

They realise that over time market prices tend to move up in line with increases in earnings per share. In dollar terms these earnings benefit from inflation, but more importantly they in addition move up in real terms because of population growth and improved productivity each year.

Actually, market values tend to increase at a faster rate than earnings because additional people are entering the market all the time and because increased savings from Australia’s ageing population look for a home. The weight of money chasing share investments, especially from superannuation funds and overseas interests, also helps to push prices up.

The demand for shares tends to exceed the supply of additional shares from new capital raisings and initial public offerings.

A short-term investor has to have the timing right on two separate occasions – when buying shares and when selling shares. Once a stock is sold it can still rise further – no one rings a bell when the price of a stock reaches its high point.

The table below shows the performance of seven well-known stocks over a normal 10-year period. If $10,000 had been invested equally in the stocks in such a portfolio on 30 June 1997 then that initial sum would have grown to $60,260 by 30 June 2007.

Dividends would have been on top of that.

Company Code Market value (cents per share) 30/06/97 Market value (cents per share) 30/06/07 Ratio Growth p.a. (%)

BHP Billiton

BHP

1948

3503

1.798

6.04

Commonwealth Bank

CBA

1600

5525

3.453

13.19

Computershare

CPU

53.125

1129

21.252

35.75

National Australia Bank

NAB

1897

4102

2.162

8.02

Westpac Banking Corp

WBC

797

2566

3.220

12.40

Westfield

WDC

488

1996

4.090

15.13

Woolworths

WOW

435

2700

6.207

20.03

           
      Average

6.026

19.67

(Prices adjusted for bonuses and share splits.)

It will be noticed that the stocks in this particular sample varied enormously in their capital appreciation, showing the importance of diversification.

Investors can also take heart from the fact that even a major disaster such as the October 1987 crash does not affect performance nearly as much as people think.

For example, if the shares in a portfolio were to increase in value by, say, 12 per cent per annum for 20 years, but at some stage within that period encounter a 50 per cent fall in market values, then the resulting capital growth would still be a satisfactory 8.18 per cent per annum.

On top of that, the investors in such a portfolio would have received income from a dividend yield of about 4 per cent per annum, which when grossed-up for the imputation credits equals 5.71 per cent. The total investor return would thus have been 13.89 per cent per annum.

The existence of capital gains tax can make shares which are already held poor selling even if they are felt to be overpriced on the market and they have reached a level at which further acquisitions would be regarded as poor buying.

Consider the following numerical example, which excludes the incidence of brokerage (which would make the transaction even less attractive):

Cost price of a particular share 100
Indexed cost price 130
Market price now 300
Hypothetical “true value” 250
Capital gains tax liability, say 46.5% of (300-130) 79
Market price net of this CGT liability = 300-79 221

Thus, while to sell a share worth 250 (in relation to alternative investments) for 300 would make sense, to sell it for an effective 221 would not.

An investment strategy popular with some investors involves putting a nominated sum of money into the market, or into a particular stock, at regular intervals for a year or two, regardless of the price level at the time of each payment. This is known as “dollar cost averaging”.

The theory behind such a strategy is that, as it is impossible to predict the bottom of any market, this approach will cause the investor to acquire more shares at times of low prices than at times of high prices. Thus the weighted average cost price will always be below the apparent average price of the shares in the time span concerned.

To illustrate, looking at just two parcels:

Buy 1000 shares @ 600 = $6000
Buy 1500 shares @ 400 = $6000

The average cost of the 2500 shares (total cost $12,000) is now 480, while the arithmetic average of 600 and 400 is higher at 500.

The trouble with this approach is that such an automatic strategy can encourage an investor to acquire a bigger exposure than might be desirable in a stock which has ceased to be a worthwhile investment.