Stocks for the long haul

Question: First of all, I really like your steady and reliable counsel. You have a great style too. Here's my question: I believe someone released a study this summer saying that bonds have generally outperformed stocks in the U.S. for decades -- most notably from 1968 through the present. Is this report flawed? If not, why aren't more people talking about it? (It seems to turn the conventional wisdom on its head?)

This link may not be the primary source, but it seems to be citing the information I heard. Dave, Queenstown, MD

Answer: One of the wrong investing mantras in recent history was that stocks weren't really risky. Sure, stocks were more volatile than bonds with an investment horizon of a couple of years. But with time stocks always outperformed bonds, turning into the investment equivalent of diamonds while bonds were cubic zirconium. The height of this thinking came with the book Dow 36,000 by James K. Glassman and Kevin A. Hassert. It was published in 1999. "The Dow Jones industrial average was at 9000 when we began writing this book," they noted in their introduction. By their calculations "in order for stocks to be correctly priced, the Dow should rise by a factor of four--to 36,000... The Dow should rise to 36,000 immediately, but to be realistic, we believe the rise will take some time, perhaps three to five years."

Oops. A closer look at the data suggests that the notion of stocks as a riskless security over the long haul is wrong. Bonds have often outperformed stocks for 10 year periods of time. Stocks did not always do better than bonds even with a 30-year time horizon before 1871, notes Robert Shiller, economist at Yale University. You don't even have to reach into the history books. From 1983 to 2008, the annual total return on stocks was 9.8% a year versus an 11% average annual return on Treasury bonds. The study you mention cuts the data a different way, but the point remains the same: There have been long periods of time when bonds have outperformed stocks.

That said, the fundamental notion informing modern finance is the proposition that returns are only earned as compensation for taking on risk. Stocks are riskier than bonds since equities represent the uncertain rewards for entrepreneurship, while bonds are long-term contracts that spell out when borrowers must make principal and interest payments. "There is no predestined rate of return, only an expected one that may not be realized," says Laurence Siegel, director of investment policy research at the Ford Foundation. "The risk of holding stocks, then, is the possibility that in the long run, returns will be terrible."

I like stocks. Stocks should do better than bonds over a very long time period. But it's the return from taking on greater financial risk. And the risk is that stocks may do poorly for a considerable period of time. I think it's a risk worth taking.

But all the uncertainty is the reason behind my bottom line: Diversify.

About the author

Chris Farrell is the economics editor of Marketplace Money.

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