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I’ll admit it.
I’ve never been a huge fan of bonds.
I even suggested once that rental property can be a better way to diversify your stock holdings without giving up most of your return as you do with bonds.
Are Stocks or Bonds the Better Investment?
This is a somewhat tricky question.
Stocks are inherently riskier than bonds, especially US treasuries – considered a near-zero-risk asset. This is because stocks provide zero guarantees of higher prices tomorrow, next month, next year, etc.
US treasuries, on the other hand, offer guaranteed interest plus the return of your capital upon maturity.
Can you lose money on bonds?
Yes, you can.
If you buy them when interest rates are low and sell before maturity when rates are higher, you’ll get a lower price than what you paid.
However, if you hold bonds to maturity, the risks you run are significantly lower.
- Inflation: Should inflation run out of control, the dollars you get back will be worth much less – but US inflation has usually been fairly tame. Even at its modern-era peak in 1979, it was just 13.3 percent. Compare that to Venezuela’s peak inflation of 1,698,488 percent in 2018!
- The US government could default on its obligations: This has never happened, and despite politicians posturing around increasing the debt limit, this is very unlikely.
To make up for the higher risk, stocks must offer higher returns on average, or nobody would buy them.
And offer higher returns they do indeed.
A Historical Comparison of Bonds to Stocks
Over the super-long term, say from 1871 to date, according to data collected by Yale economist Robert Shiller, bonds returned an average annualized 2.41 percent after correcting for inflation.
In that same period, stocks boasted an average real (i.e., inflation-adjusted) annual return of 7.03 percent. That’s more than 4.5 percent higher per year.
This makes stocks the clear winner, right?
Maybe, but what if instead of looking over a century and a half we look at a more plausible 30-year investment period?
Going back to Shiller’s data, we find that bonds brought in a lower average real annual - 1.99 percent vs. stocks’ even higher 8.10 percent - nearly 6 percent more!
Stocks for the win again, right?
Yes, but…
Will the next decade provide the same annualized returns from these two asset classes?
Will Stocks or Bonds be the Better Investment in the Coming Decade?
One of my favorite quotes of all time came from physics Nobel laureate Nils Bohr (though many mistakenly attribute it to Yogi Berra). Bohr once quipped, “It’s very hard to make accurate predictions, especially about the future!”
With this in mind, the following should be viewed as market expert forecasts, not prophesies.
According to a recent Morningstar report, US equities are expected to return between 2.8 and 6.7 percent a year over the coming 7-10 years, before accounting for inflation.
According to the St. Louis Fed, annual inflation is expected to average about 2.3 percent in the coming 10 years. This implies that US equities are expected to return a rather anemic 0.5 to 4.3 percent, i.e., between roughly half to a sixteenth of their average return in the last 30 years.
International equities are expected to return between 7.1 and 9.6 percent in nominal dollars, or 4.7 to 9.1 percent in real terms for developed markets. For emerging market equities, the expected real returns are between 2.8 and 8.5 percent.
In all three cases, these are broad ranges. Taking the median forecasts, the forecasted real annual return is 3.2 percent for US equities, 5.7 percent for developed market stocks, and 2.5 percent for developing market stocks.
None of these even comes close to the above-mentioned 8.1 percent average real annual return of US equities from 1995 to date.
How about bonds?
The Morningstar report shows forecasts ranging from 3.7 to 5.3 percent in nominal dollars, or 1.4 to 2.9 percent adjusting for the expected inflation, with a median of 2.5 percent.
Putting all the above together, you face expected returns of about 3.2 percent for US equities vs. 2.5 percent for US bonds. Thus, US stocks still edge out bonds, but a risk premium of 0.7 percent (stocks’ edge over bonds) is measly compensation for the far higher risk you take when investing in the stock market, especially one as richly priced as it currently is.
How Richly Valued Is the Stock Market Today?
The two things we know about the stock market is that on average over long periods it provides a large positive real return, but that in the short term, it can crash and burn.
To assess where the market sits in terms of valuation, Shiller averages over 10 years the price of stocks divided by earnings, what he calls the “Cyclically Adjusted Total Return Price Earnings Ratio” or TR CAPE.
The TR CAPE smooths out the short-term bumps in stock prices, providing a less volatile assessment of how richly the market is valued.
Over the past 30 years, the TR CAPE averaged 30.75. Its current value is 39.8, or 29 percent above average.
Putting this in perspective, at its pre-dot-com bust peak, the TR CAPE reached a high of 48.1, following which the NASDAQ composite index lost nearly 80 percent of its value.
Prior to the 2008 financial crisis, the TR CAPE was slightly lower than 30. From August 2008 to March 2009, the market lost 38 percent in real-dollar terms.
In early 2020, the TR CAPE peaked at 33.92. Then, the COVID-19 crash caused the S&P 500 to plunge 34 percent in a few weeks. Thankfully, that bear market was a short-lived one.
The current TR CAPE is higher than its values leading up to the two more recent market crashes.
This doesn’t necessarily mean the market will crash tomorrow or even this year. However, it does imply a higher risk of a crash, and that returns over the medium term will likely be more muted than their long-term average.
This agrees with the above-mentioned market analyst projections.
Should You Dump Stocks Now?
Far be it from me to tell you what to do.
However, here’s what I’m doing (given that I want to hit work-optional in the next couple of years) …
First, I’ve increased our bond allocation far higher than what it was in the past three decades.
Second, I’ve tilted our portfolio away from mega- and large-cap stocks more toward mid- and small-cap; from mostly US equities to a sizable allocation to foreign equities, and from growth stocks to core/value stocks.
What the Pros Say About Investing in Bonds
Mike Hunsberger, Owner of Next Mission Financial Planning says, “Your allocation, split between stocks, bonds, and/or other assets, depends on numerous factors, including when you’ll need the money, your risk tolerance, and your goals. After another outstanding year with stocks very close to their all-time highs, diversification and rebalancing are key. Your portfolio’s percentage of stocks, specifically larger growth-type stocks, has probably increased. If it’s not in line with your plan, you should rebalance back to your preferred tolerance.”
Derrick Alexander, Owner and Lead Advisor of Greater Works Wealth focuses on a major risk factor affecting fixed income. He says, “The biggest thing investors should pay attention to, from my perspective, is the U.S. debt ceiling. In the coming year, we need to address the fact that our national debt is growing too quickly. As a country, we will need to come up with a plan to service that debt or face the risk of defaulting on payments. Either outcome will significantly impact the bond sector of everyone’s portfolio.
“I believe this is an especially urgent conversation for those who are retired or planning to retire within the next couple of years. How our country handles the debt issue could influence a variety of sectors. For individuals in this demographic, it would be wise to explore alternative bond options or ensure that the bond portion of their portfolio is properly diversified. Taking prudent action now could help mitigate risks tied to this uncertainty.”
Omar Morillo, Founder & Sr. Wealth Advisor at Imperio Wealth Advisors advises, “Regarding asset allocation I have the following opinions but please understand this is not specific advice. For those in their 30s and 40s, consider an allocation of 70-90 percent in stocks and 10-30 percent in bonds to help balance growth and stability. Investors in their 50s and 60s should emphasize preservation with 60-70 percent in stocks and 30-40 percent in bonds, favoring shorter-duration, high-quality fixed income to help mitigate the risk of rising interest rates. Please understand asset allocation does not ensure a profit or protect against loss; all investing involves risk and the potential to lose principal.”
Should You Sell Stocks and Buy Bonds?
Depending on one’s stage of life, I can understand why some people shun bonds and go all-in on stocks. During our accumulation phase, I usually kept our bond allocation under 10 percent.
However, given all the above, especially if one is approaching retirement, bonds seem to offer a much better risk/reward profile than US equities or emerging market stocks, at least for the coming decade.
Among equities, developed market stocks are currently forecast to provide a higher real return.
Thus, my recommendation is to talk with your financial advisor about diversifying into bonds and/or developed market international stocks.
If there was ever a time to overweight bonds, the coming decade appears to be it.
Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.
About the Author
Opher Ganel, Ph.D.
My career has had many unpredictable twists and turns. A MSc in theoretical physics, PhD in experimental high-energy physics, postdoc in particle detector R&D, research position in experimental cosmic-ray physics (including a couple of visits to Antarctica), a brief stint at a small engineering services company supporting NASA, followed by starting my own small consulting practice supporting NASA projects and programs. Along the way, I started other micro businesses and helped my wife start and grow her own Marriage and Family Therapy practice. Now, I use all these experiences to also offer financial strategy services to help independent professionals achieve their personal and business finance goals. Connect with me on my own site: OpherGanel.com and/or follow my Medium publication: medium.com/financial-strategy/.
