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Stocks vs. Bonds, Revisited

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Real risk premiums, real rewards.

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Why Bother with Bonds?

Investors, we're told, demand a risk premium for investing in stocks rather than bonds.
But if stocks outperform bonds by as much as 5% over the long run, then for our truly long-term money, why should we bother with bonds? Why not just ignore the volatility and collect the increased risk premium from stocks?

That's the message of those who believe in "stocks for the long run" - and also from those who want you to invest in their long-only mutual fund or managed-account program. Indeed, it's always a good day to buy their fund.

One of my favorite analysts is my really good friend Rob Arnott. Rob is Chairman of Research Affiliates, out of Newport Beach, California - a research house that's responsible for the Fundamental Indexes, which are breaking out everywhere. Rob's also the only outside manager that PIMCO uses for his asset allocation abilities. In short, Rob is brilliant.

He recently sent me a research paper that will be published next month in the Journal of Indexes, entitled "Bonds: Why Bother?" The publisher of the journal, Jim Wiandt, has graciously allowed me to review it for you prior to it actually being sent out.

It's written into our investment truisms that investors expect their stock investments to outpace their bond investments over really long periods of time. Rob notes, and I confirm, that there are many places where investors are told that stocks have about a 5% risk premium over bonds.

By "risk premium," we mean the forward-looking expected returns of stocks over bonds. As noted above, if you don't think stocks will outperform bonds by some reasonable margin, then you should invest in bonds. That "reasonable margin" is called the risk premium, about which there is some considerable and heated debate.

Most people would consider 40 years to be the "long run." So, it's rather disconcerting -- or shocking, as Rob puts it -- to find that not only have stocks not outperformed bonds for the last 40 plus years, but there's actually been a small negative risk premium.

In a footnote, Rob gets off a great shot, pointing out that the 5% risk premium seen in a lot of sales pitches is, at best, unreliable, and is probably little more than an urban legend of the finance community.

How bad is it? Starting at any time from 1980 up to 2008, an investor in 20-year Treasuries, rolling them over every year, beats the S&P 500 through January 2009. Even worse, going back 40 years to 1969, the 20-year bond investors still win, although by a marginal amount. And that's with a very bad bond market in the 1970s.

Let's go back to the really long run. Starting in 1802, we find that stocks have beat bonds by about 2.5%, which, compounding over 2 centuries, is a huge differential. But there were some periods just like the recent past where stocks did, in fact, not beat bonds.

Look at the following chart. It shows the cumulative relative performance of stocks over bonds for the last 207 years. What it shows is that early in the nineteenth century there was a period of 68 years where bonds outperformed stocks, another similar 20-year period corresponding with the Great Depression, and then the recent episode of 1968-2009.

In fact, note that stocks only marginally beat bonds for over 90 years in the nineteenth century. (Remember, this isn't a graph of stock returns, but of how well stocks did or didn't do against bonds. A chart of actual stock returns looks much, much better.)


Click to enlarge

No positions in stocks mentioned.

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