Reconsidering Stock-Bond Relationships Over Time: A Historical Perspective
Editor’s Note: This is the first in a series of articles that challenge the conventional wisdom that stocks always outperform bonds over the long term and that a negative correlation between bonds and stocks leads to effective diversification. In this article, Edward McQuarrie draws from his research analyzing US stock and bond records dating back to 1792.
The CFA Institute Research and Policy Center recently hosted a panel discussion featuring McQuarrie, Rob Arnott, Elroy Dimson, Roger Ibbotson, and Jeremy Siegel. The webinar showcased divergent views on the equity risk premium and McQuarrie’s thesis. Don’t miss out on the insights shared – subscribe to Research and Policy Center to be notified when the video airs.
Edward McQuarrie:
When I share with acquaintances that I’ve compiled a historical record of stock and bond performance dating back to 1792, the common reaction is surprise – not many are aware of stocks and bonds existing two centuries ago. Jeremy Siegel’s book, Stocks for the Long Run, now in its 6th edition, provides a comprehensive look at 200 years of stock and bond returns, emphasizing the wealth potential of stocks over bonds.
My latest research, titled “Stocks for the Long Run? Sometimes Yes, Sometimes No,” published in the Financial Analysts Journal, challenges Siegel’s narrative. In this article, I will delve into those findings. But before that, let’s revisit the theoretical underpinning of Siegel’s thesis.
Risk and Return
Bonds, particularly government bonds, are considered “fixed income” assets, offering a predictable coupon and principal return at maturity. With minimal risk and guaranteed returns, their performance is steady but limited.
Contrastingly, stocks are seen as risky assets with no guarantees – investors may face total loss. Despite this inherent risk, investors, being risk-averse, seek upside potential in stocks to compensate for the higher risk compared to bonds. Hence, over extended periods, stocks are expected to outpace bonds, as evidenced by Siegel’s historical data.
The Conundrum
If stocks are projected to surpass bonds over long durations, where lies the risk? And if stocks are deemed less risky over such periods, why should they yield greater returns than seemingly less risky bonds?
This sets off a quandary – expected returns should correlate with risk, yet Siegel’s data illustrates a scenario where stocks prevail consistently without significant risk. The conundrum lies in discerning the instances where stocks underperform, introducing risk factors that validate higher returns.
The Resolution
Termed as a conundrum, the situation is easily resolved with evidence that stocks do falter occasionally, causing underperformance either absolutely or relatively to bonds. These intermittent setbacks are crucial in reinstating risk dynamics essential for earning an excess return over a benchmark such as government bonds.
My research delves into these historical shortfalls, shedding light on the fluctuations in stock and bond performance over the centuries.
The Updated Historical Record
In my Financial Analysts Journal article, I outline the methodology behind compiling the historical data. For those interested, an online appendix with detailed raw data is available for further exploration.
A graphical representation of the updated historical record offers enlightening insights:
Key Observations:
- Historically, for nearly 150 years, stocks and bonds exhibited comparable wealth accumulation, with fluctuations favoring either in a back-and-forth pattern. It was post-World War II that the performance gap widened significantly, with stocks forging ahead while bonds stagnated or fell, illustrating a shift in risk perception.
- Notably, from 1942 to 1981, stocks surged ahead substantially, outpacing bonds significantly. The stark contrast in returns during this period underscores the changing dynamics of risk and return, with bonds failing to offer the expected stability.
Reflecting on these trends, it’s evident that the narrative of consistent stock outperformance needs reevaluation, especially in light of periods where bonds proved to be a risk asset.
The title of my paper, “Stocks for the Long Run? Sometimes Yes, Sometimes No,” encapsulates the nuanced findings from this analysis.
Exploring Historical Setbacks
Looking back at events like the Panic of 1837 underscores the severity of historical market downturns. Stock market crashes from the 19th century, often overlooked, significantly impacted investor wealth, highlighting the criticality of accounting for all historic data in evaluating long-term trends.
My research captures the essence of these setbacks, providing a comprehensive view of stock performance over extended periods.
Next Steps
Stay tuned for my upcoming post addressing the relevance of historical insights in modern investment paradigms. The evolution of markets and risk dynamics offer valuable lessons for contemporary investors.
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Disclaimer: The views expressed in this article are solely those of the author and not representative of CFA Institute or the author’s employer. This article should not be construed as investment advice.
Image credit: ©Getty Images / Rudenkoi
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