Arnott: Bonds Leave Stocks in the Dust

Over the long-term, everything outperforms stocks.

July 29, 2010

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918330_grunge_carAcross most markets, stocks have been flat to negative over the past decade. Bonds have generally outperformed. There are a couple of exceptions. Emerging market stocks beat emerging market bonds over the past 10 years. And Canadian indexes at least provided a net return for the decade, in large part due to the performance of our traditional “hewing and drawing” industries – mostly rocks and what lies underneath them. But bonds still outperformed.

This 10-year failure to launch on the part of equities is by no means an anomaly, suggests asset manager, fundamental indexer and former editor of the Financial Analysts Journal Rob Arnott.

The conventional wisdom is this: “[S]tocks have beaten bonds by 5 percentage points a year for many decades, and … stock returns mean-revert, so that the true long-term investor enjoys that higher return with little additional risks in 20-year and longer annualized returns.”

Well, it didn’t work over a 10-year period. How long a period is required? “Recent events provide a powerful reminder that the risk premium is unreliable and that mean reversion cuts both ways.” Arnott writes. “[I]indeed, those 5% excess returns, earned in the auspicious circumstances of rising price-to-earnings ratios and rising bond yields, are a fast-fading memory, to which too many investors cling, in the face of starkly contradictory evidence. Most observers, whether bond skeptics or advocates, would be shocked to learn that the 40-year excess return for stocks, relative to holding and rolling ordinary 20-year Treasury bonds, is not even zero.”

But boosting bond holdings won’t help much. “One little-known fact is that the classic 60/40 balanced portfolio has roughly a 98%  correlation with stocks,” Arnott notes. Diversification has to delve deeper, and he provides a few examples beyond the 60/40 universe. “Thankfully, nothing on this graph offers [an]equity-like return, other than stocks themselves,” Arnott writes. “Everything else has performed far better.”

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