Stocks vs. Bonds: A Surprising Result

I recently received the latest Ibbotson Yearbook in the mail the other day. If you’re not familiar with it, the book is a great source for long-term returns of different asset classes (click here for more info).

What I find interesting is that the spread between the returns of stocks and bonds really isn’t that much. I think it would surprise many investors that boring bonds have held their own. Over the last 40 years, stocks have beaten bonds by a final score 10.5% to 8.4%.

The difference is theoretically due to greater risk for stocks. (Note: This is different from the usual equity risk premium which looks at stocks versus T-bills. Here I’m looking at stocks and long-term corporate bonds.)

Here’s a chart I made of stocks and long-term corporate bonds. The only difference is that I stretched out the bond returns by 2% a year.

Comments

[Paul Price:]

A 10.5% return versus an 8.4% is a 25% outperformance per year compounded [2.1%/8.4%].

How can you then conclude "isn't that much" difference?

If your paycheck was 25% better [or worse] you'd certainly think it was very significant.

2008 Apr 10 08:26 AM

[Steve E:]

To Follow up to Paul's comment, never forget the power of compounding.

$10,000 @ 10.5%/yr comes out to $542,614 over 40 years. That same $10,000 @ 8.4%/yr comes out to $251,867 over 40 years. I would say that is very significant.

2008 Apr 10 08:37 AM

[jswede:]

I think author means to convey that he'd have thought he'd get a lot more return for taking on stocks' inherent volatility.

[Difference in return] "isn't that much" is relative. To you guys, with 40 year horizons, it's a ton. For the investor that went long SPX in 2000 and is still negative, it's nothing.

2008 Apr 10 08:47 AM

[bob lee:]

We are also at the end of a bond market bull market that started in 1982. The change in rates from 14% government bonds to the 3.5% today can not happen over the next 25 years. Yes, in hindsight, it would have been wise to have bought non-callable zero coupon government bonds in 1982, but we did not.

bl

2008 Apr 10 10:11 AM

[cocomurph:]

The last time I looked , a 10.5% rate was 25% greater than 8.4%....a tremendous difference when compounded over a lifetime.

2008 Apr 10 11:18 AM

[cocomurph:]

The last time I looked, a 10.5% return rate was 25% greater than 8.4%...a tremendous difference when compounded over a lifetime.

2008 Apr 10 11:19 AM

[flyoverman:]

Eddy, if you aren't familiar with compounding and the time value of money, you should post on a different site.

2008 Apr 10 11:47 AM

[BlueOkie:]

What happens if you own both stocks and bonds? Won't the risk reward work in your favor?

2008 Apr 10 11:57 AM

[INOROUT:]

REMEMBER THAT BOND INTEREST IS TAXED AS ORDINARY INCOME , A MUCH HIGHER RATE THAT THE CAPITAL GAINS RATE AND DIVIDEND RATE OF 15% ON STOCKS. THAT IS ASSUMING OUR DEMOCRAT BRETHERN DO NOT WIN THE PRESIDENCY AND CONTROL CONGRESS.

2008 Apr 10 12:15 PM

[Eddy Elfenbein:]

Given the volatility of the premium for stocks, I don't think 2.1% is much of a reward. Over the last 10 years, corporate bonds have still outperformed stocks.

2008 Apr 10 01:32 PM

[misterbillusa:]

I also think your "straight" rising line for bonds is off. There is a much more volatility in bond prices than what is depicted by that chart.

2008 Apr 10 05:34 PM

[Eddy Elfenbein:]

Sorry Mister Bill, the chart is correct.

2008 Apr 10 11:24 PM

[jahowle:]

The chart is correct because he started with a chart of t-bills which have very little price volatility and then he added a flat 200 basis point credit spread. The average returns of either asset class are simply a benchmark but almost no one actually ever realizes any where near those average returns. Investors usually fall into one of two camps, those that outperform on a long term basis and those that under perform on a long term basis. It is not a function of which asset class you chose but what you do with it. An able minded debt investor can hang with just about any equity, currency, commodity investor over the long term. These charts simply do not reflect real world after tax, after inflatoin returns. Consider the fact that in the early 80's investors could buy long term munis yielding 12% at a time when the tax rate was 50%. These investors were earning a tax equvialent yield of 24%. I know of course they were losing a fair amount of purchasing power for a period of time but not for the life of the bond, inflation was back down to 2.50% in 1983. Equity investors were experiencing the same inflation. So much for my ramblings. Have a good weekend.

2008 Apr 11 07:12 PM

[Eddy Elfenbein:]

That's not correct. The line on the chart is of long-term corporate bonds. The source is Ibbotson Associates. I've stretched it out by 2% a year to see how well that level of premium competes with stocks. In my opinion, it does fairly well.

2008 Apr 11 07:43 PM