surinenglish

THE BIGGER PICTURE

Are bonds really safer than stocks?

Conventional investment wisdom and modern portfolio theory both hold that fixed-interest securities (bonds) are safer than equities (stocks). Most advisors will recommend to increase exposure to bonds with the investors age and to reduce risk. Careful study of the bond and equity markets shows that this conventional wisdom is not as absolute as the professional consensus would have us believe.

Professor Jeremy Siegel of The Wharton School of Finance in his classic 'Stocks for the Long Run' makes the case that stocks have in fact been less risky than bonds over the long term. When comparing the best and worst case after inflation returns for stocks, bonds and treasury bills (short term paper) from 1802, stocks are unquestionably riskier than bonds or treasury bills over one- and two-year periods. However, in every five-year period since 1802, the worst performance of stocks, -11.9%, was only slightly worse than that of bonds and bills. Over ten years stocks handsomely beat bonds and, if extending the holding period to 20 years, stock returns have never fallen below inflation, while bonds and bills have fallen several times by three per cent below the inflation rate. The worst 30-year return for stocks remained comfortably ahead of inflation by 2.6% per annum being the total average return on bonds.

Bonds cannot continue to provide returns in decades ahead as they have in the past. As interest rates have fallen, bondholders have benefited from previous high coupons (interest) and capital gains when interest rates have fallen (prices move inversely to yields). The result was a real return on bonds of 7.8% pa from 1981 to 2011 - a gain of 1% above stocks.

Today the nominal yield on a 10-year US Treasury is 1.8%. The only way that that bonds could generate a 7.8% real return is if the consumer price index fell by 6% over the next 30 years! A deflation of this type has never occurred in any economy in history. Stocks, however, can repeat their performance of the last three decades.

Over the short term, stocks are riskier than fixed income assets. It may appear riskier to accumulate wealth in stocks rather than bonds but over long periods of time, for investors with the goal of increasing purchasing power of their capital, the exact opposite is true! The safest long-term investment has clearly been a diversified portfolio of stocks. One of the greatest mistakes that investors make is to underestimate their holding period for securities, as they tend to focus on a specific stock, bond or mutual fund. The holding period that is relevant for allocation of capital is the length of time that investors hold any stocks or bonds, no matter how many changes are made to individual positions.

The author jb@ehh.gi is a member of the Society of Trustees and Estate Practitioners.

The comments and observations by the author are a reflection of his opinion and do not constitute an offer to buy and hold securities, nor does he receive any remuneration of any kind from names referred to.