Stocks vs. Bonds: Return Statistics

Let’s say you knew nothing about investing, and someone presented you with the following choices. Over the past 36 years there are two asset classes, and their return statistics are :

1973-2008 Asset Class A

Return: 9%

Volatility: 16%

MaxDD: -45%

Sharpe 6% : 0.21

Asset Class B

Return: 9%

Volatility: 9%

MaxxDD: –19%

Sharpe 6% : 0.30

Most investors would choose asset class B due to the similar returns as A, but with much less volatility and drawdown. Obviously, asset class A is stocks and B is bonds. The problem with this analysis is a big bias in the period chosen – one of largely declining interest rates and two big bear markets in stocks. If you take the results back further to 1900, the results are a little different. Here stocks handily outperform bonds, albeit with much more risk.

There are lots of observations to be made here (the cyclical nature of returns, the importance of the period chosen, path dependency, what works in the past doesn’t mean it will work in the future, etc.) but the main point I wanted to highlight here was just how much risk a 60/40 portfolio has (60% stocks, 40% bonds). An investor putting 40% of his portfolio in bonds would still have been subject to a nasty 60% decline in the value of his portfolio. This doubles the roughly 30% drawdown investors faced with a 60/40 portfolio in February. How many investors do you think have a 60/40 allocation and are willing to absorb a 30% loss, let alone a 60% loss? Timing helps on the risk management front, but that is largely due to decreasing the risk in the equity allocation.

Comments

[igggy:]

Sorry, something doesn't make sense here. The 60/40 portfolio should have the maximum drawdown of 0.6*0.45+0.4*0.19=0.346 or 34.6%. And that's assuming perfect correlation between bonds and stocks. In reality, the maximum drawdown was probably less than 30%. What am I missing here?

May 03 01:10 AM

[Old Trader:]

igggy,

A good point...hopefully the author will shed some light as to how he arrived at his DD figure for the 60/40 portfolio.

May 03 09:15 PM

[WorldBeta:]

The comments reference Feb '09, while the table only includes through 2008. Sorry for the confusion. (It also assumes monthly rebal).

Regardless, the 60/40 had a 60% drawdown in the 1930's. . .

May 04 04:09 PM

[kotika98:]

When you look at real return, after inflation, bonds will start looking relatively slightly worse.

May 05 04:31 AM

[Living4Divi...:]

Mebane - where did you get your data? Using Damodaran's data I calculated the following average returns for 73-08 (inclusive).

S&P500 10.88% - 10YrTBond - 8.55%
While the average return is not the same as the CAGR - it serves as a proxy. Using Damodaran's same data:
$100 in stocks grows to $2,372.40
$100 in Tbonds grows to $1,673.00

you picked the start of right before a great bear market in stocks and ended up in a great bear market. But, no matter, I included the full 1973 year. Here's what I used for stocks:

1973 -14.31%
1974 -25.90%
1975 37.00%
1976 23.83%
1977 -6.98%
1978 6.51%
1979 18.52%
1980 31.74%
1981 -4.70%
1982 20.42%
1983 22.34%
1984 6.15%
1985 31.24%
1986 18.49%
1987 5.81%
1988 16.54%
1989 31.48%
1990 -3.06%
1991 30.23%
1992 7.49%
1993 9.97%
1994 1.33%
1995 37.20%
1996 23.82%
1997 31.86%
1998 28.34%
1999 20.89%
2000 -9.03%
2001 -11.85%
2002 -21.97%
2003 28.36%
2004 10.74%
2005 4.83%
2006 15.61%
2007 5.48%
2008 -36.58%

For 10yr T Bonds I used
1973 3.66%
1974 1.99%
1975 3.61%
1976 15.98%
1977 1.29%
1978 -0.78%
1979 0.67%
1980 -2.99%
1981 8.20%
1982 32.81%
1983 3.20%
1984 13.73%
1985 25.71%
1986 24.28%
1987 -4.96%
1988 8.22%
1989 17.69%
1990 6.24%
1991 15.00%
1992 9.36%
1993 14.21%
1994 -8.04%
1995 23.48%
1996 1.43%
1997 9.94%
1998 14.92%
1999 -8.25%
2000 16.66%
2001 5.57%
2002 15.12%
2003 0.38%
2004 4.49%
2005 2.87%
2006 1.96%
2007 10.21%
2008 20.10%

So where did you get your data?

May 07 06:42 PM