Don't Give Up on Stocks Just Yet

Given the poor performance of stocks over the past year and decade, there has been ample discussion about the relative performance of stocks versus bonds. Some even argue that investors should allocate entirely to bonds, not only because bonds are the safer investments, but because they believe bonds will outperform stocks over the long run. In other words, if bonds can deliver higher returns with less risk, why bother with stocks?

Stocks Versus Bonds, the Past
By looking at the returns over the past 40 years (shown in Exhibit 1), the argument that bonds might outperform stocks looks to be valid. Not only have the average annual stock returns been poor over the past 10 years, but relative to bonds, stock returns look mediocre over the past 20, 30, and even 40 years. (View the related graphic here.)

But advisors should view this appearance with skepticism. First, note that over the 20-, 30-, and 40-year periods, stocks actually performed quite well, even if some bond categories did better. For the very long term, it is no longer a contest (Exhibits 2 and 3). One dollar invested in stocks 83 years ago easily outgrows $1 invested in bonds. Over almost two centuries, the returns on the stock market have been consistently high and roughly in line with stock returns over the past 40 years. (View the related graphic here.)

Long-term history provides two major insights:
1) Stocks have outperformed bonds.
2) Stock returns are far more volatile than bond returns, thus more risky. Given the additional amount of risk, it is not surprising that stocks don't out- perform bonds every period--even over extended periods of time.

Stocks Versus Bonds, the Future
How likely are stocks to outperform bonds going forward? To try to figure out the future, let us look in more detail at what happened during the past 40 years.

Despite the substantial decline in yields over the past 40 years, the bulk of the bond returns come from the income return portion, or yield (Exhibit 4). On average, the bond income return from coupon payments was more than 7%. Capital gains caused by the yield decline made up the additional return. (View the related graphic here.)

Today, yields are much lower (Exhibit 5). As of the end of the second quarter of 2009, the yield of the long-term government bond was 4.3%, and the intermediate-term government bond yield was only 2.51%. For bonds to continue to enjoy the same amount of capital gains over the next 40 years, a rough estimation would put the yield into negative territory, especially for intermediate-term government bonds. This is simply impossible, because it implies that investors would be willing to lend their money to a borrower and pay the borrower an interest rate. Over the past 40 years, bond investors have enjoyed abundant returns because of a high-yield environment followed by a steady decline in yields. (View the related graphic here.)

To analyze which asset class is more likely to outperform going forward, let's take a deeper look at the historical data and the current market environment. We analyze each component of returns going forward for stocks and bonds as follows: