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So far this century, bonds have outperformed stocks. While interest rates are low historically right now, so are stock dividend and EPS numbers. Stocks are just as expensive as bonds, in other words.

In the 20th century, especially when the bond bear market of 1940-80 is factored in, stocks outperformed bonds. But is there any reason why this might reoccur in the 21st century? By way of analogy, US companies produced more cars than any other country in the 20th century, but I don't know if this will be true in the 21st- historical data alone is not enough to convince me. On the other hand, I do expect low fee index funds to continue to outperform high fee funds, not only because they've done so historically but because I understand the reason behind it.

I welcome any thoughts on this. Thanks.

Nick







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Stocks pretty much *have* to outperform bonds over long periods of time, if humans have any semblance of rationality. This is because they are riskier than bonds.

If company profits are expected to be very low, then investors will turn to bonds, which provide a safer return. This pushes up the bond price and reduces the yield. Investors will push up bond prices enough that the yield will be lower than the return on stocks, because investors require a lower return for less risk.
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Some thoughts: I have no knowledge of what this century will bring but,
You are comparing this century (a bit over 3 years of data) with last century (100 years of data). I think most statisticians would tell you that 100 data points is better than 3 data points.
Throughout the recorded history of markets there have been periods of bull markets and bear markets some lasting for a number of years. The period of about March 2000 to October 2003 was a bear market period so the 3 years for this century includes a significant portion in one of the bear markets.
I have not idea what the next 97 years will bring but basing a forcast on the data you are comparing seems to be inappropriate.

Bob
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Stocks pretty much *have* to outperform bonds over long periods of time, if humans have any semblance of rationality. This is because they are riskier than bonds.

That's certainly true on a non-risk adjusted basis. Also on a non-risk adjusted basis, you'd expect the highest risk stocks (picture a biotech with no revenues) to outperform all others.

But does your portfolio consist only of the riskiest stocks? No, because we live in a risk adjusted world.

If bonds issued by Company X are yielding 4%, we might expect a 7% return from its stock, since we figure the stock is 3% riskier than the bond (we guess, for example, that there's a 3% chance the company will go bankrupt during our holding period and that bondholders will still get paid while shareholders do not).

So the question is, on a risk-adjusted (real world) basis, is there any reason to assume stocks will continue to outperform bonds? It seems I should expect them to perform equally on a risk adjusted basis, so I should own 50% bonds and 50% stocks.

Nick

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Hi Bob,

You are comparing this century (a bit over 3 years of data) with last century (100 years of data).

I was just mentioning recent bond outperformance as an interesting fact. My question is, ignoring history of any sort, is there a reason a diversified long term stock portfolio should outperform one of bonds.

Nick
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So the question is, on a risk-adjusted (real world) basis, is there any reason to assume stocks will continue to outperform bonds? It seems I should expect them to perform equally on a risk adjusted basis, so I should own 50% bonds and 50% stocks.

On a risk-adjusted basis, I would expect all returns to be equal.
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In the long run a widely diversified stock portfolio should out perform a bond portfolio.

The reason for this is that companies can either sell stock to pay off bonds or issue bonds to buyoff stock when the market prices are temporarily out of line for the relative risk.

Since by most measures stocks are more risky than bonds then they should outperform bonds in the long term.

Greg
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I had one more thought as I pressed the enter key. In a taxable account the advantage of stocks will be even greater since any taxes are deferred until the capital gains are realized.

Greg
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If bonds issued by Company X are yielding 4%, we might expect a 7% return from its stock, since we figure the stock is 3% riskier than the bond

I would figure the theortical stock would be 75% more risky.

7 minus 4 = 3

3/4 = 75%

Two reasons to include bonds in a portfolio.

1. High quality bonds should pay face value at maturity.

2. Portfoliow with bonds have less volatility.

3. Bonus-Dr. Ben Graham, who Warren Buffett said is the smartest person he ever met, always insisted on a minimum of 25% bonds and a minimum of 25% stock.
To which I add "the rest is details."


buzman
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Since by most measures stocks are more risky than bonds then they should outperform bonds in the long term

So you're saying the more risky the asset the better it will perform? In that case, we should invest only in the most risky securities- companies with no revenues, for example.

But we don't do this, because while on a non-risk adjusted basis we expect the most risky stocks to perform the best, we live in a risk adjusted world.

For example, I expect the biotech startup I just bought shares in to have their drug approved by the FDA, causing the stock to rise 1,000% this year (non risk adjusted). But realistically there's only a 1% chance of that happening...there's a 99% chance the drug won't make it and they'll run out of cash. So my risk adjusted return is 10%.

And so it is with stocks vs bonds. We expect stocks to outperform (non risk adjusted), but we also expect them to be riskier, reducing performance.

Nick
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And so it is with stocks vs bonds. We expect stocks to outperform (non risk adjusted), but we also expect them to be riskier, reducing performance.

Nick, are you rethinking your 120% stock asset allocation?

Gup
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Hi Gup,

I'm constantly rethinking my allocation strategy (still 120% stocks), and that of my Mother, who's 54 and has mainly Vanguard stock funds.

For my portfolio, I'm hoping the stock/bond debate will be less of an issue since the goal is to beat the market, not just track it. I'm running a controlled experiment now...if I decide I can't beat the market, I'll be in the same boat as Mom, and be more interested in bonds, REITs, CDs, etc.

Nick

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In the 20th century, especially when the bond bear market of 1940-80 is factored in, stocks outperformed bonds. But is there any reason why this might reoccur in the 21st century? By way of analogy, US companies produced more cars than any other country in the 20th century, but I don't know if this will be true in the 21st- historical data alone is not enough to convince me.

There is absolutely no proof that stocks will always outperform bonds - even over the long term. There is lots of historical evidence, but no proof. That's why brokerages and financial services always include the catch-phrase "historical returns do not necessarily indicate future returns".

That said, there is the issue of 'risk'. Risk normally has two different connotations to different people. First, risk can be thought of as whether or not a person will make a profit on an investment. This, however, is not the correct interpretation of risk, from a financial perspective.

The true definition of risk, weighs the level of volatility against the potential return. The reason that volatility is involved in the risk equation is best demonstrated in the retirement portfolio that is providing income to a retiree. The higher the volatility, the less the retiree can draw from the portfolio (to a point). In fact, there is a term known as the 'efficient frontier' where the correct compromise between volatility (risk) and return that gives the best 'safe withdrawal rate'. Historically, we have seen this rate to be at about 4% with a mix of about 75% equities and 25% bonds.

Of course, risk (volatility) is not as important to a person in the accumulation phase of life, because he/she doesn't need to withdraw money from the portfolio. That's why most younger people use higher risk, higher potential growth investments (like 100% equities) until near retirement (providing they can stomach the wide swings in value).

So, the reason that bonds are deemed less risky than stocks is not due to their potential return, but their low volatility. And, in theory, their return (and risk) could be better than stocks over long periods of time. Only time will tell. But I'm betting on equities and bonds in the right mix.

Russ
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