6.1 Historical returns and risks

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In Article 4.3 I introduced the relationship between returns and risk.  In a nutshell, the prospect of higher returns comes with a higher risk of your investment declining in value.  At a broad level, history tells us the relative returns and risks for the three main investment types are:

  • Highest for stocks
  • Intermediate for bonds
  • Lowest for cash

For cash, the average annual return is currently in the 1 to 2% range for money market accounts and short term CDs, and the risk of a decline is near zero, if we ignore inflation.  (I discuss the impact of inflation more in Article 8.)  For stocks and bonds, let’s take a more detailed look at historical returns/risks.

Historical returns

You’ll find various statistics about the historical returns on stocks and bonds, and they can be frustratingly different from one source to another depending on how the data were processed, what period was examined, and myriad other details.  Nonetheless, a close examination of various datasets paints a pretty consistent picture.  Here is a table of typical historical returns since 1926 from a recent Vanguard study.

Investment Avg. Annual Return
Stocks 10.1%
Bonds 5.4%

These returns are not adjusted for inflation, which decreases the spending power of money over time.  This is an important problem that I will come back to in Article 8, but for now, just remember that the average annual stock and bond returns presented above would be lower if they were inflation adjusted.

Historical risks

The prospect of higher returns sounds like a compelling case for stocks, but we need to also look at the risk side of the equation.  Here are some simple statistics on the ups and downs (“volatility” as measured by standard deviation) of stocks and bonds from the same Vanguard study, with standard deviations added from Burton Malkiel’s book “A Random Walk Down Wall Street”:

Statistic

Stocks

Government Bonds

Return in Best Year

54.2%

32.6%

Return in Worst Year

-43.1%

-8.1%

Years with a loss

25

14

Standard deviation

21%

6%

As you can see, stocks have a wider range of ups and downs (volatility), and in just a single very bad year, you could lose about half your investment value.  In comparison, bonds have much less potential for large intra-year losses and had fewer years where a loss occurred.  So, we can start to see why return and risk are normally assumed to be linked.

Comparing historical returns and risks

One way to simply compare stocks and bonds is put the returns and risks on a cross plot like the one introduced in Article 4.3, but using the real-world data from above.

bond-stock-risk-return-cross-plot-art-6-1

This comparison suggests that bonds are a better balance of risk and return as compared to stocks.  For example, with bonds you get about half the return, but for less than a third of the risk.  Put another way, for stocks, with every percent in return you also get about two percent of standard deviation.  In contrast, for bonds, with every percent return you get less than a percent of standard deviation.

Returns over time – So now it sounds like we should invest in bonds.  However, we should also ask: what do the different historical stock and bond returns mean for the growth of investments over time?  Here is one graph comparing the growth of a $1 investment in stocks or bonds over the same period used in the tables above.

meb-faber-60_40-bond-graph-art-61

The long term effect of the different average annual returns is apparent, with the stock value ending around $6,000, while the bond value ends up being about $100.  The lower volatility of bonds is also apparent in the chart, because the line for bonds is much less choppy than the line for stocks.  Obviously, none of us will be investing for 90 years, but the main point of the graph is to show how quickly the returns of stocks and bonds can diverge.  For example, looking at the period starting around World War II (about 1942), we can see that stocks subsequently outpaced bonds by a wide margin in just 10 years (by about 1952), and after that bonds never caught up again.

So, while the risks with stocks are clearly higher, the nearly double average annual return in stocks versus bonds has provided a huge relative benefit over the long term.  Using 1942 again as a starting point, both the stocks and bonds had about $2 value in the graph.  Just 12 years later (1954), the stock value was $10, while the bond value was still under $3.  So, even with a pretty short investing period, stocks still win handily.

You’ve probably noticed that I have not yet discussed the beginning of this chart.  It shows that for about a 15 year period starting in 1926, bonds kept pace with stocks and at some points (like 1932 and 1938), bonds performed even better than stocks, at least briefly.  This is one of the reasons I picked this particular chart.  The chief argument for bonds is that during volatile periods like the 20s and 30s, bonds provide relative stability of return.  However, it’s noteworthy that even during the Great Depression, bonds only really outperformed stocks for about a 10 year period.  I calculate this period starting from when the stock value first goes below the bond value, around 1932, and ending when the stock value stays permanently above the bond value, around 1942.

Regardless of the exact period examined, we can see that the long term returns for stocks normally mount up quickly relative to bond returns.  And even in very unusual periods, you don’t have to wait too long before the benefits of those compounding stock returns start to substantially outpace bond returns.

Risks over time – What is the “risk” being measured by the standard deviation in the above analyses?  It’s essentially how much the value of the stock or bond investments goes up and down over time.  While this is one definition of risk, is it really the type of risk that we should be concerned about?

To answer that question, let’s say that I buy an investment and sign a contract that says:

  • Upon penalty of death, I will not sell the investment for a period of 10 years and at the end of that period l must sell the entire investment.

Let’s also say that a few days after buying that investment, it becomes highly volatile and plunges 50% in value.  That’s not a great start, but given the alternative under my contract is death, I do not sell my investment prematurely.  Let’s finally say that my investment recovers and even increases in value by 34% by the end of the 10 year contract.  This equates to a 3 percent average annual increase over 10 years.  So the one-time 50% plunge caused a pretty low overall rate of return over 10 years, but the final return is still positive.  Under this scenario, there was no realization of the perceived risk implied by volatility as measured by standard deviation.  No actual “permanent loss” occurred from the 50% plunge, as frightening as that may have been.  No matter how wildly the investment varied over ten years, the primary risk that matters in this scenario is the potential for a permanent loss as measured at the end of the investment period.

Standard deviation or other measures of routine volatility are actually a very poor measure of the risk that matters most to real-life investors.  A better risk definition focuses on the potential for a permanent loss, which means that the money is not available to you when you need to spend it.  To estimate this better-defined risk, we need to overlay the expected investment volatility with the timing of when you will most likely need to use the money (investment time horizons), which is a much more complex risk analysis.  The role of time as it relates to investing risk is the subject of Article 8.

Conclusions on historical returns/risk

Our interim mindful conclusions based on the history of stock and bond returns and risks are:

  • First, the seemingly small additional annual return of stocks can reap huge benefits over periods of 10 or more years.  The return benefit of stocks can be under-estimated by focusing solely on simple annual average returns or similar metrics.
  • Second, risk defined by ordinary volatility is too simplistic, and does not determine our actual risk of permanent losses.  Depending on our investing horizons and goals, the risks associated with stocks may be over-estimated using simple measures like standard deviations.

Both conclusions indicate we should tilt our portfolios more aggressively toward stocks and away from bonds, which differs significantly from some advice you will find in the media or investing books.  Deciding how much to tilt toward stocks is a much more complex question that is linked to the risks and returns of mixed portfolios, your specific current situation, investing time horizons, and goals as detailed more in Articles 7 and 8.  But first let’s examine expected future returns/risks with stocks and bonds in Article 6.2.

 

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