If you’ve done any reading about investing, you know that stock market returns are unpredictable over short periods and predictable over long periods.

And you also know that–over long enough periods (however long those may be)–stocks outperform bonds.

However, until I started reading Jeremy Siegel’s Stocks for the Long Run, I’d never heard anyone make the case that–over extended periods–stocks not only earn greater returns than bonds, but more predictable returns as well.

In other words, not only do stocks earn more than bonds, they are actually safer investments for long-term investors.

How does Siegel reach this conclusion?

In short, he compares the range of after-inflation returns of stocks to the range of after-inflation returns of bonds over periods of various lengths. Unfortunately, the data in the edition I have only goes through 1997, and I was curious to see how the conclusion would hold up after updating for the last decade.

Time to pull out the spreadsheet and plug in some numbers!

Updated for 2008: Are stocks less risky than bonds?

The chart below shows us the best and worst stock market returns (after inflation) over periods of various lengths. As you can see, the real return from stocks becomes much more predictable as you look at longer periods.

For example, the worst 1-year real return for stocks was -37.7%, but the worst 10-year real return for stocks was a compounded -4.6%.

The next chart shows the same thing, but for bond returns (as measured by the total return on 10-year U.S. Treasury bonds). As with stocks, the returns become more predictable as we look at longer and longer periods.

The following chart essentially combines the previous two, allowing us to compare the range of bond returns (from best to worst) to the range of stock returns over periods of varying lengths.

Over short periods, the range of stock returns is much greater than the range of bond returns. For example, the worst 1-year real return for stocks was more than 90% worse than the best 1-year real return for stocks. In contrast, the worst 1-year return for bonds was just over 40% worse than the best 1-year return. (This is–in part–why people refer to stocks as “risky.”) But look at those 30-year ranges! The range of after-inflation returns for stocks actually becomes lower than the range for bond returns. In other words, stocks are more predictable (ie, safer) than bonds over periods of 30-years.

(If you compare our first chart to our second chart, you can verify this on your own: Over 30-year periods, stock returns fall into a narrower range than bond returns.)

And for any statistically-inclined readers, our final chart shows the standard deviation of real returns for stocks and bonds. Again, we see that 30-year real returns for stocks are more predictable than 30-year real returns for bonds.

What can we learn here?

If you’ve got a 30-year investment time frame a heavy allocation to stocks just makes sense–not just from a total return point of view, but from a risk point of view as well.

The catch: You can’t bail out and sell when the market drops. Otherwise you don’t get those nice, predictable 6-7% after-inflation returns.

Notes on the data:

The period considered is 1928-2008. The yearly returns are for calendar years.

Bond data and inflation data comes from the Federal Reserve Bank of St. Louis’ research site.

Stock return data is from Aswath Damodaran, Professor of Finance at the NYU Stern School of Business.

Kalinda (my wife) recently started a cooking blog. What this means for me–aside from an abundance of delicious, homemade meals–is that I end up dicing/chopping vegetables most nights. A recent close call with a chef knife got me thinking.

A few observations about chef knives:

• If used improperly, they’re dangerous.
• If used for the wrong job, they’re dangerous.
• When used correctly, and for the right purpose, they get the job done in a (fairly) safe manner.
  

Stocks are rather like a sharp chef knife:

• If used improperly (buying and selling with great frequency, or owning a portfolio that’s not sufficiently diversified), they’re dangerous.
• If used for the wrong job (short-term savings, for instance) they’re dangerous.
• When used correctly, they get the job done in a fairly safe way.

How to use stocks properly and safely?

1. Own a diversified portfolio via a low-cost fund.
2. Hold them forever (or as close to forever as you can manage).

Anybody who has ever seen a chart comparing long-term bond performance to long-term stock performance has seen that over the last century, stocks have outperformed bonds. And this is great news, because you and I both have been investing in stocks since the early 1900s, right? 😉

What’s a little more relevant is the question of whether or not we can expect stocks to continue to outperform bonds over the next several decades. After all, as every investment advisor is required to tell you, “Past performance is not an indicator of future results.” (Side note: I think that’s baloney, and so does Benjamin Graham–Warren Buffett’s mentor.)

The way I see it, there is a very fundamental reason that we can expect stocks to continue to outperform bonds over any extended period. The idea is based on a very simple truism:

Companies are in business to make money. And (overall) they’re quite good at it.

So what does that have to do with stocks vs. bonds?

Well, let’s talk for a moment about the very fundamental nature of what a bond really is. A bond is a loan that you make to a business (or a city/state). They’re borrowing your money in order to invest it in their business. And guess what? A business isn’t going to pay more in interest than it thinks it can earn with the money.

For example, let’s say a business has a project planned that it thinks will cost $10 Million and is expected to give an 8% return on investment. In this situation, what’s the most the company would pay to borrow that $10 Million? It’s pretty obvious that it’s going to be less than 8%.

So in this situation, who would you rather be? The lender, who is going to earn probably somewhere from 4-6% interest, or an owner of the business, thereby getting the 8% return?

In essence, that’s the decision you’re making when you choose between owning stocks and owning bonds. Do you want to be the business owner? Or do you want to be the lender?

What About Risk?

Of course, it’s true that in the above example the business’s projections could turn out to be wrong. They might earn less than 8% with that project. In fact, there’s a definite possibility that they earn less than the 4% (or 5%, or whatever) interest rate that they pay on the bonds, in which case it would have been better to play the role of the lender (bond owner).

However, assuming we’re talking about stock funds (index funds or otherwise), rather than individual stocks, that particular issue becomes much less of a concern. Why? Two reasons:

First reason: In the aggregate, it’s the businesses who are in control. If the business world starts to see that it’s unable to earn a profit by borrowing money at current interest rates, business borrowing slows down (that is, they start issuing fewer bonds) until market interest rates start to drop.

Second reason: There’s padding built into the system. For example, if stocks over a given period are earning 8%, you can bet that bonds aren’t paying 7.9%. Instead, they’re probably paying something in the 4-5% range. That leaves some pretty significant room for a business to overestimate its return on investment for a project and still come out ahead. (Example: If a business had an expected return on investment of 8%, it would still make money if its results were only 75% as good as expected. That is, a 6% return on investment is still profitable when borrowing at 4-5%.)

The Short Version

Companies (in the aggregate) are never going to be willing to pay a rate of interest that exceeds their rate of return on internal investments. Takeaway: Be the business owner. Not the lender.

If you knew–absolutely knew–that stocks were going to outperform bonds over your relevant investing time frame, what would your portfolio look like? Would you have the courage to put it entirely into equities?