Why Stocks Will Always Outperform Bonds Over Time

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?