The simple secret to big winners

We’ve all read stories of legendary shares that turned their owners into millionaires.

You know the type:

“Rather than drive, Grace walked around her town of Lake Forest, Ill., just outside Chicago. She bought second-hand clothes at yard sales, and owned a house that she had inherited from a friend. That one-bedroom place was stocked with the barest of possessions.
[Yet when she passed away] she left her estate of $7 million to the college to establish internship and study-abroad programs for its 1,300 students. The donation will generate more than $300,000 a year for the institution.
How did Grace Groner, a secretary for 43 years at Abbott Labs  (NYSE: ABT), manage to amass such a fortune?
It certainly wasn’t by playing the horses or winning the lottery.
Instead, Grace purchased three $60 shares of specially issued Abbott stock in 1935 and never sold them. Thanks to decades of stock splits and Grace’s practice of reinvesting dividends, her nest egg grew into millions.”

I’ve read numerous such tales over the years, and they always inspire me. They certainly beat the more common – yet rarely written – reality that would go something like this:

“Bob bought shares of Fevertree Drinks (LSE: FEVR) shortly after it floated for £2 a pop. As a drinker of their products, he was an early adopter, and always insisted on the namesake mixer when he ordered a gin and tonic…
…which he orders more often these days, when he thinks about what might have been.
You see, Bob was overjoyed when Fevertree’s shares soared 50% in a mere six months. Knowing that nobody ever went broke bagging a profit, Bob sold his shares for £3 each.
Yet fast forward two years, and Fevertree had risen another 500%, to over £17.
Meanwhile the investment Bob bought with the proceeds is up… 3%.
Bob has no plans to retire. And his old college has put its refurbishment plans on ice.”

Skew whiff

Of course, not every share compounds over the decades like Grace’s Abbot Labs did – and very few go up tenfold in three years like Fevertree.
But it’s winners like these – some more dramatic, many more less spectacular but still comfortably beating the market – that make up for all the companies that disappoint, whose shares go south, who eventually go bust.
Economists have a fancy word for the phenomenon that sees a small number of shares deliver most of the stock market gains – they call it ‘skewness’ – and it’s also one of the reasons why active fund managers find it so hard to beat index funds (along with their high fees, of course).
In the US, for example, it’s been estimated that roughly 70% of shares do worse over time than cash!

I’m a loser baby, so why don’t you sell me?

Given that only a small subset of companies drive those graphs of long-term returns from the market that go ever higher from left to right, it makes little sense to sell your winners, should you happen to find yourself owning one.
Yet that’s what many private investors do. They sell their winners and hang on to their losers.
Again, the economists have a fancy term for it: the disposition effect.
Famed investor Warren Buffett puts it more memorably. He says selling winners is like being a gardener who pulls up the flowers and waters the weeds.
Nonsensical, clearly! But sadly, I’ve sold winners for exactly the same reason everyone else does. I’ve watered my weeds.
Why? We flawed humans want to lock in our gains. Nobody wants to see the 50% price rise that made them feel so smart suddenly evaporate. So they bank the gain, where nobody can take it away from them.
We also hate losses. That is why we hang on to losers. We’re gambling that they’ll come good eventually.
They might, but statistically not by enough to make up for a strategy of consistently selling your winners.

Investing versus trading

If you aspire to someday tell your grandkids (or the local newspaper) your version of Grace Groner’s story, you’re probably going to have to find the best companies and invest in them for the long haul.
Presuming you’re a business-minded Foolish investor, it makes no sense to sell a company just because its shares have gone up 10% or 50% – or even 500%.
If the company is taking over the world – or at least its corner of it – and making money hand over fist then that’s exactly what it should be doing.
The alternative is trading. If you follow that route you’ll have to regularly and successfully spot underpriced shares, sell for a modest profit, and repeat – without making so many duff picks along the way that they whittle away your gains.
Some people can manage it, but I suspect most will find it even harder than hunting for great companies.
Find the best companies that can compound your capital over the decades, ride out the odd setback in the share price rather than trying to second guess every wobble – and let them get on with making you rich.
Like running your winners in theory but struggling in practice? Look out for my follow-up article in a couple of weeks, which will offer some tips for what to do if you’re tempted to sell a winning share!

Buy-and-hold investing

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Owain Bennallack has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.