Aren’t they risky?
Many financial experts assume so, and in terms of volatility and the risk of permanent principal depreciation, they are right. But contrary to popular perception, stocks are not necessarily riskier than supposedly “safe” assets like US Treasuries.
Let me explain.
The 10-year US Treasury yielded 2.46% in March. So the US government could borrow for a decade at 2.46% per year, and we could buy Treasury bills and lend to the US government for 10 years at 2.46% interest.
This is considered a “safe” investment since the US government has virtually no risk of default. Thus, we are more or less assured of an annual return of 2.46% over 10 years if we hold the investment until maturity.
But what if interest rates suddenly skyrocket to 10%? It hasn’t happened in decades, but a 10% interest rate is by no means unprecedented for US government bonds. Moreover, variously measured at ~6% Or 8.3%, depending on which measure is used, inflation like today has also not been seen in decades. A return to this 10% interest rate would halve the value of our “safe” Treasury bond.
But suppose US inflation stays at 6% over the next decade and we lend our money to the government at 2.46% over that period. After factoring in the cost of inflation — an interest rate of 2.46% minus 6% inflation — we would indeed be willing to –3.54% annually. If we did nothing at all and kept our money in cash or under the proverbial mattress, then in real terms, after inflation, our money would depreciate by 6% per year.
Performance of 10-year Treasury bonds: a hypothesis
Although stocks are far more volatile than bonds, that doesn’t stop bonds from producing terrible real (and even nominal) returns for both short- and long-term investors.
Of course, companies can also be affected by inflation and other macro events, and there’s no guarantee stocks will outperform inflation – certainly not in the short term, at least. Nevertheless, companies can theoretically evolve and adapt. (“Theoretically” because returns on equity for US non-financial corporations have been remarkably stable, around 11%, since World War II.) They may raise prices to pass inflation costs on to customers, reduce costs elsewhere in the business, sell real estate at inflated prices, etc. Thus, as assets, equities are better equipped to weather inflationary storms.
A bond, on the other hand, is simply a locked-in contract with no ability to adjust to inflation or any other outside influences or developments. A treasury bond, “riskless” over time, cannot adapt to changing circumstances either.
“(Financial disasters) that destroy the value of stocks have been associated with hyperinflation or the confiscation of financial wealth, where investors are often worse off in bonds than in stocks.”
Long-term returns on equities outperform other asset classes
Stock markets significantly outperform cash and bonds over time, but with much greater short-term volatility. Over a short investment horizon, we might be better off in cash or bonds. But if we’re investing for the long term – seven years or more – then equities are probably the best bet.
Our “risk” is therefore inversely proportional to our time horizon. The stock market can be bumpy in the short term, but it’s the most consistent generator of long-term wealth. This is because the y-axis in the chart above is on a logarithmic scale, so stocks have outperformed bonds by about three orders of magnitude since 1801.
For long-term investors, stocks are less volatile than they seem
The annual standard deviation of U.S. stock returns between 1801 and 1995 is 18.15%, compared to 6.14% for Treasuries, according to a study by Siegel and Thaler. However, over 20-year intervals, the standard deviation of US equity returns is actually lower than that of Treasuries: 2.76% versus 2.86%. This is despite equity yielding 10.1% CAGR versus 3.7% for Treasuries.
U.S. Equity Returns vs. U.S. Treasuries: Standard Deviation
Equity risk cannot be ignored, especially given the turmoil we’ve had in recent weeks and months. But this analysis shows that over long periods, they can be both better performing and less risky than bonds. And that makes them worth holding long-term.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
Photo credit: ©Getty Images/Nick Dolding
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