Thursday, April 23, 2009

A Really Smart Guy On Stocks, Bonds and Expected Returns

Robert Arnott IS one of the sharpest knives in the drawer. He lays out some high level thoughts in an approachable manner which, to my mind, is one of the signs of superior analytical thinking.
From IndexUniverse:

Bonds: Why Bother?

Photo BondsFor four decades, from time to time, we hear this question: Why bother with bonds at all? Bond skeptics generally point out that stocks have beaten bonds by 5 percentage points a year for many decades, and that 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.

Recent events provide a powerful reminder that the risk premium is unreliable and that mean reversion cuts both ways; indeed, those 5 percent 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.

Zero “risk premium”1? For 40 years? Who would have thought this possible?

Most investors use bonds as part of their investment tool kit for two reasons: They ostensibly provide diversification, and they reduce our risk. They’re typically not used in our quest for lofty returns. Most investors expect their stock holdings to outpace their bonds over any reasonably long span of time. Let’s consider these two core beliefs of modern investing: the reliability of stocks as the higher-return asset class and the efficacy of bonds in portfolio diversification and in risk reduction. On careful inspection, we find many misconceptions in these core views of modern finance.

Also, the bond indexes themselves are generally seen as efficient portfolios, much the same as the stock indexes. We’ll consider whether this view is sensible by examining the efficiency of the bond indexes themselves, and speculate on what all of this means for the future of bond index funds and ETFs.

Fig. 1

The Death Of The Risk Premium?

It’s now well-known that stocks have produced negative returns for just over a decade. Real returns for capitalization-weighted U.S. indexes, like the S&P 500 Index, are now negative over any span starting 1997 or later. People fret about our “lost decade” for stocks, with good reason, but they underestimate the carnage. Even this simple real return analysis ignores our opportunity cost. Starting any time we choose from 1979 through 2008, the investor in 20-year Treasuries (consistently rolling to the nearest 20-year bond and reinvesting income) beats the S&P 500 investor. In fact, from the end of February 1969 through February 2009, despite the grim bond collapse of the 1970s, our 20-year bond investors win by a nose. We’re now looking at a lost 40 years!

Where’s our birthright … our 5 percent equity risk premium? Aren’t we entitled to a “win” with stocks, by about 5 percent per year, as long as our time horizon is at least 10 or 20 years? In early 2000, Ron Ryan and I wrote a paper entitled “The Death of the Risk Premium,”2 which was ultimately published in early 2001. It was greeted with some derision at the time, and some anger as the excess returns for stocks soon swung sharply negative. Now, it finally gets some respect, arguably a bit late …

It’s hard to imagine that bonds could ever have outpaced stocks for 40 years, but there is precedent. Figure 1 shows the wealth of a stock investor, relative to a bond investor. From 1802 to February 2009, the line rises nearly 150-fold.3 This doesn’t mean that the stock investor profited 150-fold over the past 200 years. Stocks actually did far better than that, giving us about 4 million times our money in 207 years. But bonds gave us 27,000 times our money over the same span. So, the investor holding a broad U.S. stock market portfolio was 150 times wealthier than an investor holding U.S. bonds over this 207-year span. So far, so good.

That 150-fold relative wealth works out to a 2.5-percentage-point-per-year advantage for the stock market investor, almost exactly matching the historical average ex ante expected risk premium that Peter Bernstein and I derived in 2002 in “What Risk Premium Is ‘Normal’?” Those who expect a 5 percent risk premium from their stock market investments, relative to bonds, either haven’t studied enough market history—a charitable interpretation—or have forgotten some basic arithmetic—a less charitable view.