When Bonds Beat Stocks

03/31/2009 12:00 pm EST

Focus: BONDS

John Mauldin

Chairman, Mauldin Economics

John Mauldin of InvestorsInsight.com says recent research shows investors don’t get paid as much as they think for the extra risk of owning stocks.

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?

My really good friend Rob Arnott, chairman of Research Affiliates, out of Newport Beach, California, recently sent me a research paper that will be published next month in the Journal of Indexes, entitled "Bonds: Why Bother?" The entire article will be available when the Journal of Indexes goes to print in late April, at www.journalofindexes.com.

[In the article,] 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.

Most people would consider 40 years to be the "long run." So, it is 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 has actually been a small negative risk premium.

Starting at any time from 1980 up to 2008, an investor in 20-year Treasuries, rolling them over every year, beat the Standard & Poor’s 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 is with a very bad bond market in the 1970s.

Starting in 1802, we find that stocks have beat bonds by about 2.5%, which, compounding over two centuries, is a huge differential. But there were some periods just like the recent past where stocks did in fact not beat bonds.

Early in the 19th 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, stocks only marginally beat bonds for over 90 years in the 19th century.

Bill Bernstein notes that in the last century, from 1901 to 2000, stocks rose 9.89% before inflation and 6.45% after. Bonds paid an average of 4.85% but only 1.57% after inflation, giving a real yield difference of almost 5%. In the 19th century the real (inflation-adjusted) difference between stocks and bonds was only about 1.5%.

So, what is the actual risk premium? Rob Arnott and Peter Bernstein wrote a paper in 2002 about that very point. Their conclusion was that the risk premium seems to be 2.5%. Arnott writes:

"As Peter Bernstein and I suggested in 2002, it's hard to construct a scenario which delivers a five percent risk premium for stocks, relative to Treasury bonds, except from the troughs of a deep depression, unless we make some rather aggressive assumptions. This remains true to this day."

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