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Stocks vs. bonds: There’s no contest

News
Article
Medical Economics JournalMedical Economics November 2023
Volume 100
Issue 11

The stock market has inherent risks, but the common belief that bonds with the best credit ratings are virtually riskless is false.

 stock market © tadamichi - stock.adobe.com

stock market © tadamichi - stock.adobe.com

Which of the following statements is a myth?

  • Bats are blind.
  • The Great Wall of China can be seen with the naked eye from outer space.
  • Europeans generally believed the earth to be flat when Columbus first set sail across the Atlantic Ocean in 1492.
  • Bonds pose minimal risk, and stock investing is necessarily high risk.

Answer: All of them.

For most people, believing the first three myths is of little consequence. Investors who believe the fourth can significantly limit their wealth accumulation.

Sure, the stock market has inherent risks, but the common belief that bonds with the best credit ratings—Treasuries and investment-grade corporate bonds—are virtually riskless is patently false.

So persistent is this myth that it continues to thrive during the current painful period for bondholders. Bonds have been seriously damaged over the past couple years from rising interest rates, rendering them undesirable compared with new bond issues paying far higher yields. Meanwhile, stocks have come back nicely this year from last year’s bear market and, even after a pullback in September, are in what is arguably an infant bull market.

Sustaining the popularity of bonds is the false impression people get from the market analysts’ and talking heads’ obsession with bond minutia. Financial networks note the slightest fluctuation in price or yield as though they were of great and lasting importance to all investors. Treasury rate spreads are discussed ad nauseum.

Sure, these details may suggest or reflect economic trends, and they may be critical for pension funds that manage assets extremely conservatively to assure payouts. Also, bond movements might suggest future Federal Reserve board actions concerning interest rates, which can affect most investment markets, including stocks.

Yet for most stock investors, obsessing over such transitory items is pointless because they have little to do with stock market performance over really long periods. What matters is the market’s long-term direction. And over decades, this direction has been consistently upward.

Doubling Dow

Over the past 40 years or so, despite consistently unsettling news, stock market returns have been strong. During this period, the Dow Jones Industrial Average doubled five times. After finishing 1981 (my first year in the business) at 875, the Dow grew to 1,750 in 1986, 3,500 in 1993, 7,000 in 1997, 14,000 in 2007, and 28,000 in 2019. And now it’s on its way to doubling a sixth time. On Sept. 28, the Dow closed at 33,667.

According to FactSet, in the four decades from December 31, 1982 through December 31, 2022, the average annual return of the S&P 500 index of large-company stocks was 10.3%. By comparison, the average return of the Bloomberg U.S. Aggregate bond index (AGG) over the same period was 6.3%. And this was largely the 40 years known as the bull bond market, when declining interest rates benefited the bond values significantly.

So, during a strong bull market in bonds the index averaged not much more than 6% annually, and posted negative returns for three years, the worst of which was in 1994, when it lost 2.9%. Making about 6% net while losing money a few years isn’t exactly gangbusters, especially since most of the return was taxed at ordinary income rates (well above the tax rates for long-term capital gains on stocks). But this is about as good as it gets for bonds.

The superior long-term record of the stock market, including downturns, doesn’t impress doomsayer/perma-bear Jeremy Grantham. With his furrowed British brow and dour facial expression, this institutional investor habitually opines, when the market is growing apace, that doom at hand. A couple times he has been right that a market bubble would soon pop—in 2000 and 2008—but the four catastrophic predictions he’s issued since couldn’t have been more wrong. Each time, the market went up in the ensuing months. The jury is still out on Grantham’s pending predictions of a near-term recession and market crash.

This is what’s known in the investing world as a contrarian indicator: When prognosticators like Grantham say things will be bad, it’s often a good sign for the market. Dire predictions nonetheless get a lot of media attention because people are drawn to prophecies of doom regardless of actual outcomes, and the media love fear because it generates ratings and clicks.

Wild Ride

Despite its rewards, the stock market isn’t for the faint of heart. It offers no guarantees, prices can gyrate daily for no apparent reason, dividends can be cut, and sell-offs can be terrifying. It can be a wild ride.

But like a rollercoaster ride, the key to getting through it safely is to hold on, clinging to justifiable convictions and staying (judiciously) invested, unconcerned with insignificant temporary impacts.

Short-term market fluctuations are meaningful only for those trying to game them, including institutional investors and overconfident amateurs (aka day-traders) who let transitory events dictate, as poet T. S. Eliot wrote, “decisions and revisions that a minute will reverse.”

Reversing investment decisions can be quite costly. Reacting reflexively to every market twitch is no way to live, and frequent trading is usually counterproductive. Instead, individuals should do research to make informed decisions—or get recommendations from a qualified advisor—and then stick with them; discipline and patience are critical for successful stock investing.

For investors who try to game the market, a steep drop can be like, or perhaps cause, a heart attack. Many individual investors who think bonds are reliably secure associate stock investing with this kind of angst. They’re not familiar with the prudent practice of calmly selecting and maintaining a stock portfolio with care and temperance, and having the patience to ride it down in a decline and then ride it back up when the market rebounds. (It always has.)

Even fewer investors understand how economic and market conditions can, like cancer, eat away at bond values. When this cancer is inflation, for bonds held until maturity, it can significantly reduce the buying power of principal and interest.

And over the past few years, one of the best reasons to own bonds—portfolio diversification—has faded. Previously, bond prices tended to move in a different direction than stock prices, but now these price movements are more correlated. Thus, bonds’ effectiveness as a portfolio diversifier is diminishing.

Volatility Isn’t Risk

Many investors assume that stocks are inherently risky because of market volatility, but they mistakenly equate volatility with risk. Renowned investors including Warren Buffett say emphatically that volatility isn’t the same as risk. Buffett should know. His stock holding periods are epically long, allowing him to benefit from long-term gains unaffected by short-term volatility.

Conflating volatility with risk, many stock investors become paranoid when the market turns herky-jerky. But if volatility rattles them enough, perhaps they shouldn’t own stocks in the first place, just as people with heart conditions shouldn’t ride rollercoasters. Yet understanding that volatility is pretty much inconsequential in the long run can be like seeing a cardiologist for preventive care.

The biggest actual risk from investing in general, Buffett and other experts agree, is permanent loss of capital—something investors with well-chosen stock portfolios are unlikely to experience if they hold stocks long enough. Contrary to popular belief, loss of capital is a real risk for bondholders because loss of buying power is effectively the same thing.

The Road Ahead

Though the long run is what matters, investors seeking to invest new money naturally want to do so amid favorable market conditions.

The fourth quarter usually delivers good market performance. This year, it comes as the economy—and to the extent that it’s related, the stock market—are getting closer to long-term normalcy after unprecedented disruption from the pandemic, federal efforts to repair its economic damage and the impacts of these impacts.

Of course, normalcy includes inevitable market pullbacks and corrections. Yet, despite annual corrections, normally about 70% of the time the S&P 500 has enjoyed increases over 12-month periods. Normalcy can be highly beneficial, and if harnessed correctly, it can pose far less risk than many investors believe and deliver far greater rewards than bonds ever could.

Dave S. Gilreath, CFP, is a founding principal and CIO of Sheaff Brock Investment Advisors, an investment firm for individual investors, and Innovative Portfolios®, an institutional money management firm. Based in Indianapolis, the firms manage assets of about $1.3 billion. The investments mentioned in this article may be held by those firms, Innovative Portfolios’ ETFs, affiliates or related persons. There may be a conflict of interest in that the parties may have a vested interest in these investments and the statements made about them.

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