Stock Returns Superior to Bonds

Recently, I saw a 79-year old chart that proved stock returns are vastly superior to bonds.  Should I forget bonds and just concentrate on stocks?

No – The chart is both historically accurate and highly misleading.  Investors are often statistically seduced by such historical “proof” because they fail to understand the context in which the history was written.  The relationship between stock and bond returns is a case-in-point.  For a real story of stock vs. Bond returns call Guard line.

Stocks vs. Bonds

After reference to the long-term chart starts in 1926 from the next ten years stocks would suffer years of tremendous losses and 10 years later would have compounded annual returns of 5.9%.  Bonds would lose money only one year (1931 – a mere 1.9% loss), and end the 10 years with compounded annual return of 7%.  In fact it isn’t until the end of 1944, that stocks begin to edge out bonds after a 19 year period with stocks compounding at 5.8% per year and bonds at 5.6% per year.

The prudent investor of the late 1940’s could conclude on thing: bonds were for investors and stocks were for speculators.  Is it any wonder that during the late 40’s and early 50’s the U.S. Govt. could set the interest rate on long term bonds of 2%.  History had “proven” that bonds were a superior investment.  Investors in the 50’s felt stocks should pay significantly higher dividends yields than bonds because dividends were not reliable.  Back then stocks paid a 6% dividend and government bonds paid 2%.  Today stocks an average 2% and government bonds pay 7%.

Back to our story, unfortunately the prudent investor would be left in the dust.  The eye of consumerism, installment buying and an explosive in birth rates was about to unfold.  From the beginning of 1945 to the end of 1964, stocks produced a compounded annual return of 14.9% or 10,000 invested in 1945 which would be worth $160,942 bonds over the same period in turn produced a 2.5% annual compounded return.  Return or 10,000 invested in 1945 would be worth a mere 16,386 in 1964.

The proven superiority of stocks vs bonds in the 50’s would narrow considerably over the next 20 years as social events arised such as: The VIETNAM war, oil price shocks, inflation, and a vicious bear market ending in 1974.  From beginning in 1964 to end of 1983: 10,000 invested stocks would be worth 45,570.  Compared with 25,057.  The period is an important one for bond markets – during those 20 years, interest rates became deregulated and bond investors were forced to become more sophisticated. They had to – in the 70’s and early eighties, the government punished bond holders with high inflection and high interest rates eroding the value of their holdings.

For the next 10-year bonds, a great environment for both stocks and bonds would unfold environment of declining inflection and lower interest rates.  10,000 stocks would really be worth $40,000 vs. the same bonds worth – nearly 37,000 @ 13.97% compounded a 14.86% compounded annual return.

To summarize from 1926-1944 – for nearly two decades bonds were a superior investment to stocks – especially on a cost adjusted basis.

1944-1964 – stocks blow bonds away as a superior investment in fact it is this period that gives stocks the long term lead that in the big 70 year picture makes bonds look pathetic.

The 20 year stock period from 1964 -1983 proves a superior investment but the margin of superiority shrinks dramatically more importantly the entire interest rate sensitive sector of the economy including the money market fund is invested deregulates (banks, savings, and loans) and bond market professionals become increasingly sophisticated.

The 10-year stock period from the beginning of 1983 to the end of 1993 is on a balance nirvana for stocks and bonds.  The superiority of stocks over bonds shrinks dramatically again, with stocks compounding @ nearly 15% per year and bonds compounding @ nearly 14% per year.  The bond market has continued to evolve, and would be unrecognizable to the investor of the 1943 – 1963 period.

Today the role of the bond markets has been transformed from can you imagine the US Govt. telling bond holder that inflations is the law, trust us, were going to pay you 2% on your bond as they did in the 1940’s and 1950’s?  Today the market tells the government what interest rate it will pay.  In fact markets now tell governments what monetary policy to follow by increasing interest rates in any country that appears to have inflationary risks; that are not properly addressed.

In summary basing investment decisions on the historical returns of stocks vs. bonds is without context, in which the returns were produced.  Once you understand the context in which historical returns are created, you should appreciate how irrelevant historical returns can be.

So you may ask what should I base my investment decision on?

Unfortunately the answer to that question is neither simple or short, nor universal.