Don't Believe Stocks Always Beat Bonds? Read This

Summary

• Are stocks or bonds a better investment?
• Both have pros and cons.
• But stocks tend to outperform bonds in the long term.

It's one of the most common questions we get asked…

"Are stocks or bonds a better investment?"

The confusion is understandable. And to average investors who are looking to restructure their investments or simply mobilize some cash they have lying around, it's a topic worth shedding light on.

Stocks offer unlimited upside. It's how legendary investors like Peter Lynch have managed to make record returns over the long term (Lynch made 29 percent annual returns for 13 years by investing in stocks).

But stocks also expose you to a company's potential failure. And how well management runs the company is often reflected in the value of each share. We've also written before of how, because of the way our minds are wired, the prospect of losses scare most investors from stocks.

Meanwhile, bonds are a fixed income investment. A bondholder is promised a rate of interest (his return) over a certain period of time. So when you buy a bond, you basically know how much you're getting at the end, assuming you hold on until maturity. Bonds generally offer a higher degree of safety and security than stocks.

But bonds aren't without risk. Bonds issued by corporations have the risk that the business could fail and leave bondholders with huge losses. And government-issued bonds are assured by the government, unless the government becomes unable to meet its financial obligations or its currency significantly loses value.

So which is the better investment?

What 90 years of data tells us

According to the Ibbotson SBBI Yearbook, a study of historical capital market returns, U.S. stocks have generally outperformed all other U.S. investment classes since the 1920s.

Only during the two decades, covering the 1930s and the 2000s, did bonds outperform stocks. And even then, the difference in returns weren't overwhelmingly in favor of bonds.

In the 2000s - a period that included the global financial crisis - long-term U.S. corporate bonds returned 7.6 percent, while government bonds returned 7.7 percent. Meanwhile, large cap stocks lost 0.9 percent, while small cap stocks gained 6.3 percent. Since then, both large cap and small cap stocks have more than made up for their underperformance, with a 12.8 percent and 15.3 percent increase, respectively, from 2010 to 2016.

And last year, the Dow Jones and S&P 500 experienced one of their best years on record - both indices surged 24 percent and 21 percent, respectively.

Over the past 90 years (up to 2016), U.S. stocks have returned nearly twice as much as the best performing bonds (long-term corporate bonds), and up to three times better than typical U.S. Treasuries. And small cap stocks returned nearly four times as much as U.S. Treasuries.

A mere US$1,000 invested in U.S. small cap stocks in 1926 would have grown into over US$29 million by 2016.

That same US$1,000 would have grown into just US$20,269 when invested in U.S. Treasuries… and US$189,464 when invested in long-term U.S. corporate bonds.

And looking beyond the U.S. … since 2010, global equities (the S&P Global Large Cap Index and the MSCI Asia Ex-Japan Index) have seen compound annual growth rates of 6.0 percent and 5.7 percent, respectively.

That's, on average, twice as much as the annual gains seen in the S&P International Corporate Bond Index (2.4 percent) and the S&P Pan Asia Corporate Bond Index (3.8 percent) during the same period.

Which stocks you buy matters

But just because historical data shows that stocks beat bonds, it doesn't mean you should just buy the S&P 500 today.

Great investors like Peter Lynch are successful because they invest in the right stocks.

So how do you find the right stocks?

Lynch has 20 "Golden Rules" he follows in his investment philosophy. But I think these are the five most important ones:

1. Know what you own, and know why you own it. This is a basic requirement for anyone who is serious about investing in stocks. You should approach buying one share the same way as if you were buying all the shares.

Would you buy an entire company without knowing exactly what it does, where it gets its profits, what factors could affect the business and the outlook for its industry? I don't think so.

2. Carefully consider the price-to-earnings ratio. This is the share price of a stock divided by the amount of earnings per share. It shows how many years it takes for a company to generate profits equivalent to its current market value.

You shouldn't necessarily buy stocks that just have low P/E multiples. You need to consider a stock's P/E relative to its industry average and main competitors. If the stock is grossly overpriced, even if everything goes right, you won't make any money.

3. Don't buy into the fad-of-the-moment. Avoid hot stocks in hot industries. These are the stocks that will likely already have an army of analysts covering them, and where the smart money has already taken a position.

Instead, look for great, well-managed companies in overlooked industries that are consistently delivering profits for shareholders. They tend to be the big winners.

4. Never invest in a company without understanding its finances. This means taking the time and effort to study financial statements and understand the strengths and weaknesses of a company's business. Is it highly leveraged? Does it have enough cash to sustain its business going forward? If you can't understand the balance sheet, you probably shouldn't own it.

5. You have to be patient. The typical big winner in the Lynch portfolio generally took three to ten years (or more) to play out. If you invest US$1,000 in a stock, all you can lose is that US$1,000. But if you followed the other rules, chances are you'll stand to gain US$10,000 or even US$50,000 over time if you're patient. Patience also allows you to leverage the wealth-creating power of compound returns.

One of my biggest successes was recommending an obscure real estate development company called China Resources Land back in 2003, when few analysts were covering the Chinese real estate market. The company grew its business 50-fold over the next 15 years, and turned every US$1,000 invested into as much as US$34,880.

In short, a portfolio of well-chosen stocks will always outperform a portfolio of bonds or Treasuries. However, a portfolio of poorly chosen stocks won't even outperform the money you leave under the mattress.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.