Why Stocks Are Less Risky than Bonds

Risk and return are the building blocks of finance and portfolio
management.Once the risk and expected return of each asset are
specified, modern financial theory can help investors determine the
best portfolios.

But the risk and return on stocks and bonds are not physical constants.

Despite the overwhelming quantity of historical data, one can never be
certain that the underlying factors that generate asset prices have
remained unchanged.

One must start by analyzing the past in order to understand the
future.You can remember the first presentation is prepared by friends
showed that not only have fixed-income returns lagged substantially
behind those on equities but, because of the uncertainty of inflation,
bonds can be quite risky for long-term investors.

In this chapter one shall see that because of the changing nature of risk
over time, portfolio allocations depend crucially on the investor’s
planning horizon
For many investors, the most
meaningful way to describe risk is by
portraying a “worst-case scenario.” The
best and worst after-inflation returns for
stocks, bonds, and bills from 1802 over
holding periods ranging from 1 to 30
years are displayed in Figure 2-1.
Maximum and Minimum Real Holding Period Returns, 1802 through December 2006

Note that the height of the bars, which measures the difference
between best and worst returns, declines far more rapidly for
equities than for fixed-income securities as the holding period
increases.

Stocks are unquestionably riskier than bonds or Treasury bills over
one- and two-year periods. However, in every five-year period since
1802, the worst performance in stocks, at –11 percent per year, has
been only slightly worse than the worst performance in bonds or bills.

And for 10-year holding periods, the worst stock performance has
actually been better than that for bonds or bills.

For 20-year holding periods, stock returns have never fallen below
inflation, while returns for bonds and bills once fell as much as 3
percent per year below the inflation rate for two decades. This
wiped out almost one-half the purchasing power of a bond portfolio

For 30-year periods,the worst returns for stocks remained
comfortably ahead of inflation by 2.6 percent per year, a return that
is not far from the average return on fixed-income assets.
Many investors, although convinced of the longterm superiority of equity, believe that they should
not invest in stocks when stock prices appear high.
But this is not true for the long-term investor. The
after-inflation total return over 10-, 20-, and 30-year
holding periods after the eight major stock market
peaks of the last century is shown in Figure 2-2.
Average Total Real Returns after Major TwentiethCentury Market Peaks ($100 Initial Investment).

Even from major stock market peaks, the wealth accumulated in
stocks is more than four times that in bonds and more than five times
that in Treasury bills if the holding period is 30 years.

If the holding period is 20 years, stock accumulations beat those in
bonds by about twoto-one.

Even 10 years after market peaks, stocks still have an
advantageover fixed-income assets. Unless investors believe there is
a high probability that they will need to liquidate their savings over
the next 5 to 10 years to maintain their living standard, history has
shown that there is no compelling reason for long-term investors to
abandon stocks no matter how high the market may seem.

if investors can identify peaks and troughs in the market,they can
outperform the buy-and-hold strategy.
The risk—defined as the standard deviation
of average real annual returns— for stocks,
bonds, and bills based on the historical
sample of over 200 years is displayed in
Figure 2-3. Standard deviation is the
measure of risk used in portfolio theory and
asset allocation models.
Risk for Average Real Return over Various Holding Periods, 1802 through
December 2006 (Historical Risk versus Risk Based on Random Walk
Hypothesis)

Although the standard deviation of stock returns is higher than for
bond returns over short-term holding periods, once the holding
period increases to between 15 and 20 years, stocks become less
risky than bonds. Over 30-year periods, the standard deviation of a
portfolio of equities falls to less than three-fourths that of bonds or
bills. The standard deviation of average stock returns falls nearly
twice as fast as for fixedincome assets as the holding period
increases.

Theoretically the standard deviation of average annual returns is
inversely proportional to the holding period if asset returns follow a
random walk. A random walk is a process whereby future returns are
considered completely independent of past returns. The dashed
bars in Figure 2-3 show the decline in risk predicted under the
random walk assumption.

Even though the returns on bonds fall short of that on stocks, bonds
may still serve to diversify a portfolio and lower overall risk. This will be
true if bond and stock returns are negatively correlated, which
means that bond yields and stock prices move in opposite
directions. The diversifying strength of an asset is measured by the
correlation coefficient. The correlation coefficient, which
theoretically ranges between –1 and +1, measures the correlation
between an asset’s return and the return of the rest of the portfolio.
The lower the correlation coefficient, the better the asset serves as a
portfolio diversifier. Assets with negative correlations are particularly
good diversifiers. As the correlation coefficient between the asset
and portfolio returns increases, the diversifying quality of the asset
declines.

The correlation coefficient between annual stock and bond returns
for six subperiods between 1926 and 2006 is shown in Figure 2-4.
Correlation Coefficient between Monthly Stock and Bond
Returns

From 1926 through 1965 the correlation was only slightly
positive, indicating that bonds were fairly good
diversifiers for stocks.

From 1966 through 1989 the correlation coefficient
jumped to +0.34, and from 1990 through 1997 the
correlation increased further to +0.55.

This means that the diversifying quality of bonds
diminished markedly from 1926 to 1997.
Modern portfolio theory describes how investors
may alter the risk and return of a portfolio by
changing the mix between assets. Figure 2-5,
based on the 200-year history of stock and bond
returns, displays the risks and returns that result
from varying the proportion of stocks and bonds in
a portfolio over various holding periods ranging
from 1 to 30 years.
Risk-Return Trade-Offs for Various Holding Periods, 1802 through December 2006

The square at the bottom of each curve represents the risk and
return of an all-bond portfolio, while the cross at the top of the curve
represents the risk and return of an all-stock portfolio. The circle
falling somewhere on the curve indicates the minimum risk
achievable by combining stocks and bonds. The curve that
connects these points represents the risk and return of all blends of
portfolios from 100 percent bonds to 100 percent stocks. This curve,
called the efficient frontier, is the heart of modern portfolio analysis
and is the foundation of asset allocation models.

Investors can achieve any combination of risk and return along the
curve by changing the proportion of stocks and bonds. Moving up
the curve means increasing the proportion in stocks and
correspondingly reducing the proportion in bonds. As stocks are
added to the all-bond portfolio, expected returns increase and risk
decreases, a very desirable combination for investors. But after the
minimum risk point is reached,increasing stocks will increase the
return of the portfolio but only with extra risk.
Portfolio Allocation: Percentage of Portfolio Recommended in Stocks
Based on All Historical Data

What percentage of an investor’s portfolio should be invested in
stocks?

The answer can be seen in Table 2-2, which is based on standard
portfolio models incorporating both the risk tolerance and the
holding period of the investor.7 Four classes of investors are
analyzed: the ultraconservative investor who demands maximum
safety no matter the return, the conservative investor who accepts
small risks to achieve extra return, the moderate-risk-taking investor,
and the aggressive investor who is willing to accept substantial risks
in search of extra returns.
Until the last decade, there was no U.S. government bond
whose return was guaranteed against changes in the price
level. But in January 1997, the U.S. Treasury issued the first
government-guaranteed inflation- indexed bond. The
coupons and principal repayment of this inflationprotected bond are automatically increased when the
price level rises, so bondholders suffer no loss of purchasing
power when they receive the coupons or final principal.
Since any and all inflation is compensated, the interest rate
on this bond is a real, or inflation adjusted, interest rate.
No one denies that in the short run stocks are riskier than
fixed-income assets. But in the long run, history has shown
that stocks are actually less risky investments than bonds.
The inflation uncertainty that is inherent the paper money
standard that the United States and the rest of the world
have adopted indicates that “fixed income” does not
mean “fixed purchasing power.” Despite the dramatic
gains in price stability seen over the past decade, there is
still much uncertainty about what a dollar will be worth two
or three decades from now. Historical evidence indicates
that we can be more certain of the purchasing power of a
diversified portfolio of common stocks 30 years in the future
than the principal.
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