Bonds will occasionally outperform the stock market in the short run, but over the long haul, stocks still tend to come out on top. So don’t lose faith in your equities, says Money Magazine's Walter Updegrave.
Question: The conventional wisdom is that stocks should outperform bonds over the long haul. But over the past 10 years, Vanguard's Total Bond Market Index fund has had a slightly higher return than Vanguard’s Total Stock Market Index fund with a lot less volatility. Have fundamentals in the market changed such that stocks no longer offer a premium return? --David Poston
Answer: You hear the mantra repeated so often - stocks beat bonds over the long term - that it’s become an absolute truth for many investors.
But while it may be comforting to believe there is at least one completely reliable standard you can always count on in an investing world rife with uncertainty, the fact is that virtually all truisms have exceptions and qualifications
One big qualifier to the “stocks trump bonds” rule is the length of time you expect your money to remain invested. Or, to put it in terms former president Bill Clinton might use, it depends on what the meaning of “long term” is.
If your idea of long-term investing is ten years, history shows that while stocks usually excel over that period of time, it’s not unprecedented for bonds to sometimes come out on top. Indeed, if you go to the bible of investment performance data - Ibbotson Associates’ "Stocks, Bonds, Bills and Inflation Yearbook" - and compare returns for the 73 rolling 10-year periods starting with 1926-1935 and continuing through 1998-2007, you’ll find that bonds outgained stocks in 11, or 15%, of those periods.
The usual reason that bonds manage to buck the trend every now and then is that stocks occasionally become overvalued. That’s exactly what happened back in the late '90s. Giddy investors pushed stock prices to bloated levels, the market crashed and money invested in stocks at or near peak prices ended up earning subpar long-term returns. Thus, it was the irrational exuberance of the go-go '90s that resulted in bonds beating stocks over the past 10 years.
But given enough time, stocks have historically shown that they’ve been able to bounce back, even from extremely bloated prices and eventually overtake bonds. So, for example, if you extend your notion of long term to 20 years, there’s only one of 63 rolling 20-year periods since 1926 in which bonds beat stocks: 1929-1948, the 20 years after the Crash of '29 that ushered in the Great Depression. And if you extend that time frame by just one year to 1949, stocks come out ahead.
I don’t want to suggest that stocks’ superiority is guaranteed (although as I pointed out in an earlier column, there are rational reasons to expect stocks will outperform). But I do think that history makes a compelling case that even if you buy stocks at the worst times, you’ve still got a chance of earning higher returns than in bonds if you hold on long enough. Of course, that doesn’t provide much comfort if you need the money and your stock investments are still faring poorly before “long enough” arrives.
As to whether fundamentals have changed so that stocks are no longer likely to deliver higher returns in the future, I don’t see anything that suggests that’s the case. Yes, we’re definitely in a challenging period right now. We’ve lurched from a stock-market bubble to a real estate bubble and now we’re mired in a credit crunch.
But these sorts of convulsions and crises, while unsettling, are a normal part of the ebb and flow of economies and markets. We’ve been through such episodes before and we’ll go through them again. If anything, I’d argue that all this fear and anxiety makes it less likely that stocks are poised for long-term inferior returns. I’m more wary of stocks when investors can’t shovel money into them fast enough because they’re convinced stocks are a sure thing. That’s when stock prices are most apt to become gaseous and their future return prospects dimmest.
It would be wonderful if we knew ahead of time when stocks are going to generate killer returns and when they’re going to be dogs. But until someone finds a way of developing this sort of clairvoyance, revving up a tool like our Asset Allocator and then investing in a mix of stocks and bonds that reflects how long your money will be invested and your tolerance for risk is the best way I know to deal with the uncertainty inherent in investing.