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Are Stocks Really Riskier Than Bonds?

For short term investors, stocks are indeed riskier than Bonds. But for long-term investors the evidence from actual historical returns indicates that Bonds were actually riskier than stocks. But it all depends on having a proper definition of what risk means.

Let me be blunt and rather arrogant.

When it comes to long-term investors, virtually the entire investment community is focused on the wrong definition of risk. Much of what is written about risk is at best inappropriate and at worse completely wrong for a long-term investor. This is caused by an over emphasis on short-term volatility.

For long-term investors we need to have a proper definition of risk. Financial academics and the investment community generally define risk as the short-term (annual, monthly or daily) volatility of returns from an investment. The volatility of returns is measured by variance or standard deviation. 

From the perspective of a long-term investor, this definition of risk is flawed for two reasons:

1. The analysis and conclusions almost always focuses on the volatility of annual (or even monthly or daily) returns. An annual focus might be appropriate for many investors, but long-term investors should be mostly concerned about risks associated with their long-term wealth level and not primarily focused on the bumps along the way.

2. The analysis and conclusions are almost always based on nominal returns and ignore the erosion of purchasing power caused by  inflation. For short term investors, inflation may not a be a big concern but it has a huge impact in the long-term.

As to the second point above, it seems self evident that better conclusions will be reached using real (inflation adjusted) returns rather than nominal returns. 

As to the first point above, under the annual volatility definition of risk, stocks are considered much more risky than long-term Bonds or Treasury Bills. Yet, it is a fact that stocks have significantly outperformed both Bonds and T-Bills over 30 year periods. In each and every 30 year "rolling window" from 1926 - 1955 through to 1975 - 2004, stocks have provided a higher (after inflation) return.  But due to higher annual volatilities, stocks are considered more risky! To avoid risk (annual volatility) you are advised to put some money into Bonds or T-Bills which in fact are almost guaranteed to under perform stocks in the long run. This kind of thinking on risk is hazardous indeed to your long-term wealth. (That is, if your goal is wealth maximization at some distant point like 20 or 30 years in the future, as it is for many investors).

The following graph shows the actual annual volatility in Stock, Bond and T-Bill returns from 1926 to present. In regards to stocks, this discussion deals only with the performance of the S&P index of large company stocks as a group it does not deal with the risks of investing in a non-diversified portfolio of stocks. The data here is for U.S. returns as published by Ibbotson Associates in their Yearbook entitled, Stocks, Bonds, Bills and Inflation. (Ibbotson SBBI classic yearbook).

Sure enough, the stock returns (the blue line) are far more volatile on an annual basis. long-term Treasury Bond returns (the red line) are also quite volatile while T-Bill returns are generally quite stable. It's also fairly obvious that the average stock return is much higher than the average Bond return which in turn is much higher than the average T-Bill return.

On a real return basis, stocks have had calendar year losses of over 30% in four of the 69 years since 1926, with the latest occasion of course being 2008. And two (1930/1931 and 1973/1974) of those occasions included an adjacent calendar year with a loss of at least 20%, meaning the total loss was around 50%. Using daily data there would be more occasions when stocks have plunged at least 50% from a previous peak. That is certainly real risk and is hard to stomach. Yet we know that despite this stocks have clearly out-performed bonds in the long run.

The age-old question for investors is whether or not the (highly probable but perhaps not certain) higher average return from stocks justifies the extra risk (annual volatility). 

In judging the risk of Stocks versus Bonds, I think you must consider more than the annual volatility. The following illustrates this.

In regards to the stock market and annual volatilities of returns you simply cannot analyze your risk unless you first consider how many years that you will be investing. It is generally accepted that the average investor is concerned very much with annual returns and has a one year time horizon. Most of the discussion you will ever see about stock market risks will focus on the one year volatility. That might be fine for the mythical average investor but it leads to completely wrong conclusions, for long-term investors. 

For a long-term investor, I would argue that the more relevant risk is clearly the risk of insufficient growth in long-term real purchasing power. Analysis which focuses on the risk of short term volatility in wealth or returns is quite simply looking at the wrong risk when it comes to the long-term investor. 

ACTUAL RETURNS IN THE MARKET STOCKS vs. T-BONDS vs. T-BILLS

Each point on the above graph shows the compounded annual return from holding each asset class for 30 years ended in the year shown on the "X" axis. For example the leftmost points on the graph indicates that the average compounded return from holding stocks (S&P index) for the 30 year period ended in 1955 was about 8.5% while holding the ten year treasury bond earned about a compounded 2.1% and holding treasury bills for that 30 year period earned just less than 0.0%, in all cases the returns are after accounting for inflation.

The above graph shows that for 30 year rolling investment periods ranging from 1926 - 1955, all the way to 1977 - 2008, real (after inflation) stock returns were significantly higher in each and every 30 year period. In fact T-Bills which are supposed to be safe are almost a guarantee that your return will at best barely outpace inflation in the long run. Treasury Bonds rarely returned more than a compounded 2% (after inflation) over 30 year periods. To my way of thinking, this graph illustrates that over 30 year investment periods stocks have not been riskier than bonds given that they always outperformed bonds over these historical 30-year holding periods. If the future is like the past, then we might be justified in concluding that stocks will continue to outperform bonds over a 30-year investment period.

What the above graph does not show is how volatile the annual returns were. For example, in any given 30 year period, stocks always won out in the end, but they may have subjected the investor to horrifying volatility along the way.

The 30 year stock returns are riskier in terms of volatility of results but clearly are not riskier in terms of what really should matter most (to long-term investors), long-term growth in wealth and purchasing power. It seems wrong-headed to consider a return that historically varied between 4% and 10% per year, after inflation, (this is over 30-year periods) to be riskier than the return on treasury bills, which never got above 2.0%, after inflation.

Most investment theory teaches that the risk versus return trade-off is a matter of personal preference. The stock market offers higher average returns on stocks but at the cost of higher annual volatility. To their credit, the industry encourages those with longer term time horizons to use a higher equity weighting but still advises that all investors allocate some funds to Bonds and Bills. But this really offers little guidance to investors.

My conclusion is that the risk return trade-off is more a matter of time horizon and education, rather than personal preference. If you are virtually certain that you will not require the funds prior to 20 years or more, then history teaches that stocks have not been riskier. Stocks will almost certainly return more than Bonds or Bills (based on historic data).

If investors are educated about this then most of them can become more comfortable with the daily, monthly and annual volatility of stocks safe in the knowledge that high returns in the long-term is their almost certain destiny. It's a bit like taking a drive on a mountain road with a lot of switchbacks. If you don't know the road, the switchbacks and back-tracking might be highly stressful (as you think you are going in the wrong direction). But if you have studied a map carefully then you can relax and the switchbacks will not bother you since you know that the road to your destination will be circuitous.

Most investment advice advocates holding a balanced portfolio of stocks, bonds and cash.

The above graph illustrates exactly what would have happened to an investor following a partly balanced approach of 30% bonds and 70% stocks or following a more fully balanced 50%, 25%, 25% stocks, bonds and cash (bills) allocation. This assumes U.S. data and that stocks are represented by the S&P index, bonds by 10-year U.S. government bonds and cash by 30-day U.S. government Treasury bill investments. This assumes annual re-balancing to maintain the balanced allocation. There is no speculation in this data, only historical reality.

The result is that the partially balanced portfolio significantly under-performs a 100% stock portfolio in about half of the 69 different rolling 15 year periods. There were about 21 cases where the balanced portfolio was only slightly below the 100% stock approach. The partially balanced approach was superior only for the 6 periods that started in 1926 through 1931 and ending in 1940 through 1945 and as well in the 15 year periods ended 2002, 2007 and 2008.  The more fully balanced portfolio trailed the stock returns by a significant  margin most years but did beat the stocks in the 15 year periods ended 1940 through 1944, as well as 1974, 1982, 2007 and 2008. And holding the partially balanced portfolio came at the expense of very noticeable under performance compared to 100% stocks in about half of the 15 year rolling periods. The underperformance was much more pronounced with the more fully balanced portfolio.

Since stock portfolios began in the late 20's or began at the end of 1993 and 1994 did not out-perform long-term government Bonds over the next 15 years, it might be wise to refrain from investing 100% in stocks during times where stocks seem to be clearly over-valued, if one can identify that. However, if you have a least a 15 year investment horizon, the odds (based on this historical data) appear to be very much in favor of the 100% stock portfolio, based on past results, the odds of significantly beating the stock returns with a balanced portfolio over any 15 year period appear to be quite slim.

The above graph illustrates that over the 51rolling 30 year periods ending in 1955 through 2006, Balanced portfolios have almost always noticeably under-performed 100% stock portfolios. (with the notable exceptions of the 30 year period ended in 2002, where 30% stocks, 70% bonds portfolio equaled the 100% stock portfolio and the 30 year period ended 2008 where the 30% stocks, 70% bonds managed to beat the 100% stock approach). And this even includes stock portfolios that were set up in 1928, just before the massive stock crash of 1929 - 1932. Note that in more recent periods Balanced Portfolios have under-performed by a smaller percentage over 30 year periods. This leads many to conclude that result is to be expected in future. Not so, Balanced Portfolios nearly kept pace with stocks in more recent years only because of the dramatic drop in interest rates. Now that interest rates are at historic lows, that situation will likely not occur in the near future.

Proponents of Balanced Portfolios often argue that you will only give up a small amount of return and will get lower annual volatility. But note that a $100,000 stock portfolio growing at say 8% (after inflation) grows to $1,006,300 in 30 years, while a Balanced portfolio growing at say 6.0% grows to only $574,300. So, the stock portfolio in this case is worth a hefty 75% more. So much for giving up a "small" amount of return!

Over 10 year investment horizons, stocks have only occasionally under-performed Treasury Bonds or Treasury Bills. If you plan on spending the money within 10 years it would be risky to allocate all of your funds to stocks, but it would seem wise to place a significant portion of your funds in stocks since stocks usually have the highest return, based on this historical data.

Summary

In regards to stocks, this discussion deals only with the performance of the S&P index of large stocks as a group it does not deal with the risks of investing in a non-diversified portfolio of stocks.

For shorter term investments the stock market is very risky compared to Bonds and short term treasury Bills. The average return from stocks has been consistently higher over long periods but over shorter periods (anything under 10 to 15 years) the results from stocks are hugely uncertain. It would be most unwise indeed to invest money needed next month or next year or even prior to 10 to 15 years in 100% stocks

As the time horizon lengthens, we reach a point where stock returns are almost (but never quite) certain to exceed Bond and Bill returns - at least based on historical U.S. results from 1926 through 2008. For time horizons exceeding 15 years it seems quite unlikely that stocks will under perform Bonds and virtually certain that they will out perform Bills. With a 30 year time horizon it seems virtually certain (based on history) that stocks will outperform Bonds. A 100% (diversified) stock portfolio seems virtually certain to outperform, over 30 year periods, portfolios with any portion of the funds allocated to Bonds or Cash.

This analysis was based on making an initial investment and letting it grow over time.

Of course, if one is capable of expertly timing the markets then it would be possible to beat the 100% stock approach in the long-term by "simply" being in the highest returning asset class each year. This will be attractive perhaps to psychics and clairvoyants. Mere mortals investing for 15 years or longer might wish to consider the 100% stock approach. However, investors that are uncomfortable with annual volatility should use a balanced approach. And it may be realistic for long-term investors to move some money out of stocks if stock prices are in an obvious bubble.

Virtual certainty is not quite 100% certainty there is always some small chance that Bonds will outperform even in a 30 year time horizon. 

You don't have to agree with my conclusions. You can also study the graphs above and draw your own conclusions.

Self-described long-term investors need to be sure that they really have a long time horizon before they act accordingly. For many investors, there is a chance that they will need to cash out their investments early. This could be caused by illness, job loss, disability, legal problems and other reasons. But, if an investor is virtually certain that they have a very long time horizon then it certainly appears that stocks (based on a U.S. large stock index) are not riskier than bonds.

Shawn Allen, CFA, CMA, MBA, P.Eng.

President, InvestorsFriend Inc.

Article created, June 2001 and last updated February 20, 2009