By LARRY SWEDROE
As the chief research officer for Buckingham Strategic Wealth, I’ve received a series of calls about the May 1, 2020, New York Times article Bonds Beat Stocks Over the Last 20 Years by Jeff Sommer. With that in mind, I thought I would share my thoughts on it.
Sommer began by noting: “You can count on stocks to beat bonds over the long haul. That, at least, is the common wisdom, and much of the time it has even been true. But not over long stretches lately.” He added: “Over the last 20 years — which counts as a very long time for me — investments in important kinds of bonds have outperformed the stock market. That includes long-term Treasuries, long-term corporate bonds and high-yield (or junk) bonds. It is true even after the startling rally in the stock market since March 23.”
Sommer then exclaimed: “The remarkable performance of bonds… is a sign of how unreliable many assumptions about financial markets actually are these days — of how risky the markets have become and of how difficult it is to invest sensibly for the future.”
He added: “Neither stocks nor bonds have been behaving as expected.” He then showed that from 2000 through April 2020, the S&P 500 (5.4 percent return) had underperformed long-term Treasury bonds (8.3 percent), long-term corporate bonds (7.7 percent) and high-yield bonds (6.5 percent).
We’ll begin our discussion by analysing the observations that the performance of bonds over the last 20 years has been remarkable and how risky investing has become, making it difficult to invest sensibly.
Bonds beating stocks for long periods is not unusual
We’ll begin by noting that it’s critical for investors to understand that all risky assets (like stocks and bonds) experience very long periods of underperformance. That must be the case, or there would be no risk for a long-term investor — all they would have to do is wait out the bear market. Consider the following:
- There have been three periods of at least 13 years when the S&P 500 underperformed what is considered the riskless benchmark, one-month Treasury bills — the 15 years from 1929 to 1943, the 17 years from 1966-82, and the 13 years from 2000-12. That’s 45 total years out of the last 91. Of course, over the other 45 years, there were huge equity risk premiums. But the only way you earned those great returns was if you were there all the time.
- Over the 20-year period from 1929 to 1948, the S&P 500 underperformed five-year Treasuries, and over the even longer 21-year period 1929-49, they underperformed long-term (20-year) Treasuries.
- Over the 17-year period from 1966 to 1982, the S&P 500 underperformed five-year Treasuries (though it outperformed long-term Treasuries).
- Over the 31+-year period 1990 through April 2020, the Japanese large stock index, which returned 0.0 percent, underperformed the Japanese bond index by 4.4 percent per year.
- Over the 40-year period 1969-2008, U.S. large and small growth stocks (Fama-French research indexes), which returned 8.5 percent and 4.7 percent, respectively, underperformed long-term Treasuries, which returned 8.9 percent.
While Sommer observed “the remarkable performance of bonds… is a sign of how unreliable many assumptions about financial markets actually are these days — of how risky the markets have become”, history demonstrates that there was really nothing that unusual. We have “been there and done that.” In other words, there was nothing unusual about such periods for those who know their investment history, providing a good example of why one of my favourite sayings is that there is nothing new about investing, only the investment history you don’t know.
We now turn to the issue of expected returns and Sommer’s observation that “neither stocks nor bonds have been behaving as expected”.
While it’s true that stocks have higher expected returns than safe Treasury bonds (there should always be an ex-ante equity risk premium), that is only true in the sense of the mean expected outcome. Wise investors know to not think about expected returns in a deterministic way. Instead, they know to think about them in a probabilistic way. And given the very risky nature of stocks (the annual standard deviation for the S&P 500 has been about 20), they know that they have to think about a possible wide dispersion of potential outcomes, including the fact that stocks might underperform safe bonds for a very long time.
A Monte Carlo simulation we ran at the end of 2019 showed that based on current yields and valuations, there was about a 10 percent chance the S&P 500 would underperform riskless one-month Treasury bills over the next 10 years and about a 3 percent chance this would occur over the next 20 years. Thus, if the S&P 500 does underperform those one-month Treasury bills over the next 20 years, it should not be an unexpected event, just one with a low likelihood of occurring. There’s a big difference between those two statements. Unfortunately, my 25 years as chief research officer have taught me that two common mistakes investors make is that they treat the unlikely as impossible and the likely as certain.
With these concepts in mind, what’s the expected (mean) returns for financial assets?
The best estimate we have for real equity returns over the next decade comes from current valuations — the Shiller CAPE 10 earnings yield provides the best estimate for future real equity returns. For U.S. stocks, that provides a real expected return of about 4 percent. For developed markets, it’s about 5 percent. And for emerging markets, it’s about 8 percent.
If we compare that to the real yield on 10-year TIPS, about -0.4 percent, we have a fairly robust equity risk premium, even for the U.S. However, remember the caution to treat those estimates as just the mean of a wide dispersion of potential outcomes.
Let’s now turn to a key point that Sommer missed. While noting that the S&P had underperformed both investment-grade corporate bonds and high-yield bonds over the period, he did not note that both those riskier bonds underperformed the much safer Treasury bonds. Importantly, the outperformance of safer Treasuries was greatest during the times it was needed most:
- From October 2007 through February 2009, the S&P 500 lost 50.2 percent, the ICE BofA High Yield Index lost 26 percent, and long-term investment-grade corporate bonds lost 2.7 percent, while long-term Treasuries gained 17.8 percent.
- From February 2020 through March 2020, the S&P 500 lost 19.6 percent, the ICE BofA High Yield Index lost 13 percent, and long-term investment-grade corporate bonds lost 0.8 percent, while long-term Treasuries gained 12.5 percent.
Just when the diversification benefits of safe bonds were needed most, to dampen the risk of the overall portfolio, they performed best. Which is why, when building individual bond portfolios, our firm limits holdings to Treasuries, FDIC-insured CDs and AAA/AA-rated municipal bonds that are also either general obligation bonds or essential service revenue bonds.
Hedge your bets
We now turn to Sommer’s conclusion, with which I fully agree: “The import of all of this is not that investors should load up on either bonds or on stocks. It is to hedge your bets. No one knows what the next 20 years will look like for financial markets, or even the next few months.”
I would add, however, the following. Your plan should be sure to consider that there is a wide possible dispersion of potential outcomes, and it should address all of them. It should also include a “Plan B” — the actions you will take if the left tail of the potential distribution becomes the reality in order to ensure that your plan doesn’t fail, leaving you without sufficient financial assets to live the life you desire. And finally, you should be sure that you don’t take more risk than you have the ability, willingness or need to take. A Monte Carlo simulation is the tool we use to help clients make the most informed decisions.
Before concluding, I want to note that my first thought on reading the article was that it reminded me of the infamous Death of Equities article, which appeared on the cover of Business Week on Aug. 13, 1979. From September 1979 through December 1999, the S&P 500 returned 17.6 percent per annum, producing a total return of 2,594 percent. Thus, the rumours of the death of equities were premature.
Investing is always about taking risks; there are no certainties. That is why it’s critical that your plan not take more risk than you have the ability, willingness or need to take. And the fact that all risky assets (whether U.S. stocks, international stocks, emerging market stocks, small stocks, large stocks, growth stocks, value stocks, real estate, Treasuries, corporate bonds, reinsurance, selling volatility insurance and so on) will experience long periods of underperformance is not a reason to avoid risks. It’s a reason to diversify risks across as many unique sources of risk and return you can identify that meet the criteria of having provided a premium return that has been persistent, pervasive and intuitive, as well as surviving implementation costs.
You want to hyper-diversify because if you believe that the markets are highly efficient, you should also believe that all risky assets should have similar risk-adjusted returns. And that should lead you to avoid concentrating risk in any one, two or just a few risk baskets.
The following are good examples with which to conclude:
- While the S&P 500 Index was underperforming totally riskless one-month Treasuries over the 17-year period 1966-1982, U.S. small value stocks (Fama-French small value research index) outperformed the S&P 500 Index by a cumulative 1,117 percentage points (1,323 percent vs. 206 percent).
- From 2000 through 2012, while the S&P 500 was underperforming those riskless Treasury bills, Vanguard’s Small-Cap Value Index Fund (VISVX) outperformed its S&P 500 Index fund (VFINX) by a cumulative 176 percentage points (298 percent vs. 122 percent), and Dimensional’s Small-Cap Value Fund (DFSVX) outperformed by an even greater amount, 231 percentage points, providing a total return of 353 percent. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends Dimensional funds in constructing client portfolios.)
- Over the 40-year period 1969-2008, U.S. large and small growth stocks (Fama-French research indexes), which returned 8.5 percent and 4.7 percent, respectively, underperformed long-term Treasuries, which returned 8.9 percent. Over the same period, large and small value stocks (Fama-French research indexes) far outperformed, returning 11.6 percent and 14.5 percent, respectively.
On the other hand, over the last several years, growth stocks (and the S&P 500) have far outperformed value stocks. Again, that’s why we diversify, not concentrate, risk — all crystal balls are cloudy. Which leads to my final words of caution: Avoid the temptation to try to time markets, thinking that you or your financial advisor are likely to be successful.
While winning the market timing game is possible, the odds of doing so are so poor it’s not prudent to try. One reason is that much of market returns comes in very short and unpredictable bursts. For example, while the recession caused by the great financial crisis continued through the second quarter of 2009 and the unemployment rate continued to rise through the end of the year, from March 2009 through year-end, the S&P 500 returned 55 percent! If an investor was simply waiting for the economic news to get better, they would have missed one of the greatest market rallies in history.
In closing, consider these words of caution offered by the late John Bogle in his book Common Sense on Mutual Funds: “The idea that a bell rings to signal when investors should get into or out of the stock market is simply not credible. After nearly 50 years in this business, I do not know of anybody who has done it [market timing] successfully and consistently. I don’t even know anybody who knows anybody who has done it successfully and consistently.”
Important disclosure: Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of actual portfolios nor do indices represent results of actual trading. Information from sources deemed reliable, but its accuracy cannot be guaranteed. Performance is historical and does not guarantee future results. Total return includes reinvestment of dividends and capital gains.
When constructing client portfolios my firm recommends Dimensional Fund Advisors funds to clients.
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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