Are Stocks Riskier Than Bonds?

By SJS Investment Services Investment Associate Bobby Adusumilli, CFA.

You have probably heard the saying, “Stocks are riskier than bonds.” The idea is that if investors take greater risk, they should get rewarded with a higher return over time; therefore, since stocks are riskier than bonds, then stocks should have higher returns over time. While the logic seems to make sense, we wanted to look at the historical data to answer the question: are stocks actually riskier than bonds?

The answer is: it depends on how you define risk. If you define risk as portfolio fluctuations over the short-term, then stocks have generally been riskier than bonds. However, if you define risk as loss of wealth over the long-term, or as lost opportunity to grow wealth over the long-term, then you may be surprised to learn that stocks may not actually be much riskier than bonds.

We want to illustrate these points via graphs. We use the S&P 500 Index as representative of the U.S. stock market, and the Bloomberg Barclays U.S. Aggregate Bond Index as representative of the U.S. bond market.[1][2] We want to focus on increases in purchasing power, so we use the U.S. Consumer Price Index (CPI) to calculate real (inflation-adjusted) returns.[3] Additionally, in order to use as much reliable historical data as we can, we chose the S&P 500 Index that has available data since 1926, while the Bloomberg Barclays U.S. Aggregate Bond Index has data since 1976.

It’s important to emphasize that indices are not directly investable. Before the last few decades, it was difficult for an individual to invest similar to a broadly-diversified index in a low-cost, tax-efficient, trading-efficient way. Therefore, it is unreasonable to expect that any investor could have matched the index returns below. However, with the increasing popularity of index funds over the past 25 years, an individual investor has a much greater ability to achieve returns similar to a well-known index in a low-cost, tax-efficient, trading-efficient way going forward.[4]

Risk: Portfolio Fluctuations Over The Short-Term

The U.S. stock market tends to fluctuate a lot from year-to-year. Since 1926 using end-of-year data, yearly real returns have ranged from -38% to +58%, rarely staying flat.

Source: Dimensional Returns Web. See “Important Disclosure Information” below.[1]

Comparatively, the U.S. fixed income market has been much more steady. Since 1976, yearly real returns have ranged from -10% to 27%, with most returns within the range of -7% to 7%.

Source: Dimensional Returns Web. See “Important Disclosure Information” below.[2]

These graphs above support the argument that stocks are riskier than bonds, if you define risk as fluctuations in value over the short-term.

Risk: Loss Of Wealth Over The Long-Term

Since 1945 based on end-of-year data, the U.S. stock market has not had a negative 20-year real return. The annualized 20-year real returns have ranged from 1% to 15%.

Source: Dimensional Returns Web. See “Important Disclosure Information” below.[1]

Similarly since 1995, the U.S. bond market 20-year real return has never been negative. The annualized 20-year real returns have ranged from 3% to 7%, and have generally been steadier than the U.S. stock market.

Source: Dimensional Returns Web. See “Important Disclosure Information” below.[2]

It’s surprising, but if you define risk as loss of wealth over the long-term, then U.S. stocks have not actually been much riskier than U.S. bonds over longer-term periods.

Why This Matters

You may be wondering why the definition of risk matters. To demonstrate, this graph below shows the real growth of $100 for both the U.S. stock market and U.S bond market since 1976. Although U.S. stocks had significantly greater short-term fluctuations than U.S. bonds, $100 grew to $3,184 for the U.S. stock market, compared to $510 for the U.S bond market. A big difference.

Source: Dimensional Returns Web. See “Important Disclosure Information” below.[1][2]

If you define risk as short-term fluctuations in value, then you may be tempted to invest more in bonds than in stocks. Conversely, if you define risk as long-term loss of wealth or lost opportunity to grow wealth, then you may be able to better withstand the yearly fluctuations in favor of more stocks. As Jeremy Siegel wrote in his best-selling book, you may be able to commit yourself to “stocks for the long run”.[5]

Considerations

Because of evolving needs, many investors use different definitions of risk at different periods of time as well as for different accounts. There are many legitimate reasons to focus on short-term portfolio fluctuations - and thus potentially invest more in bonds - including:

• Cash flow needs in the short-term and / or intermediate-term

• Potential expected return benefits through diversification and rebalancing

• Belief that the stock market will not continue to provide positive returns in the future

• Ability to psychologically withstand large market fluctuations

• Focusing more on current self compared to future self

If you have varying goals and time horizons for your wealth, then you can consider the following:

• For shorter-term (<5 years) cash flow needs, you can define risk as short-term portfolio fluctuations, and focus more on bonds.

• For longer-term (10+ years) investing (e.g., 401(k), IRA, savings for future children / grandchildren), you can define risk as long-term loss of wealth, and focus more on stocks.

• For intermediate-term (5-10 years) cash flow needs, you can combine the definitions of risk, and use a balanced portfolio of stocks and bonds.

Conclusion

Many investors have greatly benefitted from investment markets historically (particularly stocks), and we expect investors to continue to benefit going forward.[6] Defining how you think about risk can significantly impact your future returns. If you have any questions or want to talk about your situation, please feel free to reach out to us.

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Important Disclosure Information & Sources:

[1] The S&P 500 Index is a free float-adjusted market-capitalization-weighted index of 500 of the largest publicly traded companies in the United States.

[2] The Bloomberg Barclays US Aggregate Bond TR USD Index measures the performance of investment grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM passthroughs), ABS, and CMBS.

[3] The US Bureau of Labor Statistics Consumer Price Index (CPI) All Urban Seasonally Adjusted is a measure of the average monthly change in the price for goods and services paid by urban consumers between any two time periods. It can also represent the buying habits of urban consumers. This particular index includes roughly 88 percent of the total population, accounting for wage earners, clerical workers, technical workers, self-employed, short-term workers, unemployed, retirees, and those not in the labor force.

[4] “Index Funds Are the New Kings of Wall Street“. Dawn Lim, 28-Sep-2019, wsj.com.

[5] “Stocks for the Long Run 5/E: The Definitive Guide to Financial Market Returns & Long-Term Investment Strategies“. Jeremy Siegel, 2014, McGraw-Hill Education.

[6] “SJS 2021 Capital Markets Expectations: Making Sense Of The Future“. SJS Investment Services, 04-Feb-2021, sjsinvest.com/blog.

There is no guarantee investment strategies will be successful. Past performance is no guarantee of future results. Diversification neither assures a profit nor guarantees against a loss in a declining market.

Indices are not available for direct investment. Index performance does not reflect the expenses associated with management of an actual portfolio. Index performance is measured in US dollars. The index performance figures assume the reinvestment of all income, including dividends and capital gains. The performance of the indices was obtained from published sources believed to be reliable but which are not warranted as to accuracy or completeness.

Statements contained in this report that are not statements of historical fact are intended to be and are forward looking statements. Forward looking statements include expressed expectations of future events and the assumptions on which the expressed expectations are based. All forward looking statements are inherently uncertain as they are based on various expectations and assumptions concerning future events and they are subject to numerous known and unknown risks and uncertainties which could cause actual events or results to differ materially from those projected.

Hyperlinks to third-party information are provided as a convenience and we disclaim any responsibility for information, services or products found on websites or other information linked hereto.

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Bond Returns – Could The ‘Drought’ Be Ending?

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By SJS Director of Institutional Investment Management Kirk Ludwig

Whether you’re an SJS client living in Ohio or Arizona – or somewhere in between – chances are good that you have experienced an environmental drought at some point during your lifetime.

In the bond market, we have been experiencing our own version of a “drought” over the past decade – a shortage of income (or, yield) from our bonds, with respect to the fixed income allocations in our MarketPlus® portfolios. A drought begins and intensifies when there is a continued shortage of rainfall. Over time, the ground dries up. The “green” goes away as plants, shrubs, and trees die or fall dormant. The ground remains fertile but, in the absence of precipitation to generate new growth, crops fail to produce their yield.

Typically, we think of bonds, or fixed income, as the “safer” part of our portfolios, since they generate income while providing portfolio stability. However, since the Great Recession in 2007, short-term bond rates have hovered near zero percent, evaporating any income from this part of the portfolio.[1] Now that the U.S. economy is feeling more stable, the Federal Reserve has increased their target rate to 2.25%, which in turn has showered the bond market with a much needed income boost.[2]

Similar to how a gentle rainfall would not immediately end a weather drought, a gradual increase in interest rates doesn’t automatically lead to higher income. When interest rates go up, the principal value of a bond will actually adjust lower to make up for the higher market rate. This adjustment period often dampens fixed income returns in the short-term, but leads to a higher income stream in the future. As a result, the returns in fixed income investments year-to-date in your portfolio have been fairly flat.

We are eager to start capturing greater yields, but we have to be patient. In the current interest rate environment, the bond portion of our MarketPlus portfolios will gradually start capturing the increase in rates as shorter-term bonds mature and proceeds are reinvested at today’s higher yields. The Federal Reserve will likely continue to raise short-term rates in the near future, which means bond returns may continue to be flat for a while. However, we believe that we will soon start to see evidence of higher yields as they sprout within the portfolios.

A recovery following a drought is gradual. It doesn’t happen like a flood – instantly inundating. The recovery occurs by having a steady, soaking rain for a few days or more. Before you know it, your resources are recovering and the drought has ended.

Our hope is that our client portfolios start to benefit from these drought-ending rate increases, and that their future “harvest” will be more bountiful.

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Sources:

[1] Daily Treasury Yield Curve Rates, U.S. Department of the Treasury.

[2] U.S. Rates and Bonds, Bloomberg.com.

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