Aren’t they risky?
Many financial experts assume so, and in terms of volatility and risk of permanent principal deterioration, they are right. But contrary to popular perception, stocks are not necessarily riskier than supposedly “safe” assets like US Treasuries.
let me explain
The 10-year US Treasury yielded 2.46% in March. So the US government could borrow for a decade at a rate of 2.46% per year, and we could buy Treasury bonds and lend to the US government for 10 years at 2.46% interest.
It is considered a “safe” investment since the US government has virtually zero risk of default. So, we are more or less guaranteed a 2.46% annual return for 10 years if we hold the investment until maturity.
But what if interest rates suddenly shoot up to 10%? It hasn’t happened in decades, but a 10% interest rate is by no means unprecedented for US government bonds. Also, measured differently at ~6% or 8.3%, depending on the metric used, inflation like the current one has also not been seen in decades. A return to that 10% interest rate would halve the value of our “safe” Treasury bond.
But let’s assume that US inflation stays at 6% for the next decade and that we lend our money to the government at 2.46% during that time. After taking into account the cost of inflation—an interest rate of 2.46% minus 6% inflation—we would actually lend to -3.54% annually If we did nothing and kept our money in cash or stuffed under the proverbial mattress, then in real terms, after inflation, our money would depreciate by 6% per year.
Yield on 10-year Treasury bonds: a hypothetical
While stocks are much more volatile than bonds, that doesn’t stop bonds from producing horrendous real (and even nominal) returns for investors over short and long-term time frames.
Of course, companies can also be negatively affected by inflation and other macro events, and there’s no guarantee that stocks will outperform inflation, at least not in the short term. However, theoretically companies can evolve and adapt. (“Theoretically” because returns on equity for US non-financial firms have been remarkably stable, around 11%, since World War II.) They can raise prices to pass on the costs of inflation to customers , cut costs elsewhere in the business, sell them real. real estate at inflated prices, etc. Thus, as assets, stocks are better equipped to weather inflationary storms.
A bond, on the other hand, is simply a locked-in contract with no facility to adjust for inflation or any other external influence or development. A Treasury bond, “risk-free” as it is over time, also cannot adapt to changing circumstances.
As Jeremy Siegel and Richard Thaler note:
“[Financial disasters] that destroy stock values have been associated with hyperinflation or the seizure of financial wealth, where investors are often worse off in bonds than in stocks.”
The long-term returns on stocks are higher than other asset classes
Equity markets outperform cash and bonds over time by a wide margin, albeit with much greater short-term volatility. Over any short investment horizon, we may be better off in cash or bonds. But if we’re investing for the long term (seven years or more), stocks are probably the best bet.
Our “risk” is therefore inversely related to our time horizon. The stock market can be chaotic in the short term, but it is the most consistent wealth generator in the long term. In fact, the y-axis in the chart above is on a logarithmic scale, so stocks have outperformed bonds by about three orders of magnitude since 1801.
For long-term investors, stocks are less volatile than they appear
The annual standard deviation of US stock returns between 1801 and 1995 is 18.15%, compared to 6.14% for Treasuries, according to research by Siegel and Thaler. Over 20-year intervals, however, the standard deviation of returns for US stocks is actually lower than for Treasury bonds: 2.76% versus 2.86%. This is despite stocks returning 10.1% CAGR compared to 3.7% for Treasuries.
US Stock Returns vs. US Treasuries: standard deviation
Equity risk cannot be dismissed, especially given the turbulence we’ve seen in recent weeks and months. But this analysis shows that over extended periods of time, they can be both more profitable and less risky than bonds. And that makes them worth keeping for the long term.
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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.
Image credit: ©Getty Images/Nick Dolding
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