Challenging Assumptions

It's repeated so often it has almost become a financial planner's mantra: Over 20 years, stocks always beat bonds. Look back on history, the refrain continues, and you'll see, the pattern has held true generation after generation. It's time to reconsider that assumption. History does not necessarily repeat itself, and it's far from certain to do so in the next 20 years. In fact, it's perfectly possible

It's repeated so often it has almost become a financial planner's mantra: Over 20 years, stocks always beat bonds. Look back on history, the refrain continues, and you'll see, the pattern has held true generation after generation.

It's time to reconsider that assumption. History does not necessarily repeat itself, and it's far from certain to do so in the next 20 years. In fact, it's perfectly possible that, for the first time in any living person's career, U.S. stocks will not perform as well as bonds in the next couple of decades.

Looking Back, Looking Over

True, U.S. stocks outperformed bonds in all separate 20-year periods in the last century (1900 to 1919; 1920 to 1939; and so on). But there are good reasons to avoid unquestioning acceptance of the premise that the averages set for the last century will hold true into this century.

The main argument for skepticism: The sample is too small to be reliably predictive. A century, after all, consists of only five 20-year periods. To have some confidence, we would need to analyze at least a dozen 20-year periods. The U.S. stock market has not existed for long enough to enable the U.S. to undertake such an analysis.

To address this quandary, we need another source of market data. A useful one is a study of 15 other countries' market trends gathered by analysts Elroy Dimson, Paul Marsh and Mike Staunton, all of the London Business School. Although the data do not relate directly to U.S. stocks and bonds, they do provide U.S. investors with more scenarios by which to judge the long-term relevant risks of stocks and bonds in general.

Another reason to add other markets is that our view of stocks is overoptimistic if we use data only from those markets that have survived during the last century. The U.S. is not only a surviving market, but one of the strongest of the surviving markets.

Yet other markets did not operate continuously during the 20th century. The ravages of World War II, the switch to communist forms of government and other events caused some markets to cease operating for some of the time. Germany, Japan, Russia, Argentina and Portugal are examples. By excluding such markets we are not taking all variables into account. Indeed, doing so is similar to analyzing the performances of only those money managers who have survived rather than all money managers. By doing so, we base our results only on those who were successful.

We also can add the recent experience of Japan as a reminder of what can happen to equity markets. There, stocks have underperformed bonds for the past 14 years. This is a flourishing economy that suddenly hit the skids, sending stocks plunging from highs of a 40,000 Nikkei average in 1990 to today's level of one-fourth that number.

By including international data, we boost the number of discrete 20-year periods to 80.

I Can See Clearly Now

We then find that stocks have outperformed bonds only 82 percent of the time.

These figures — and the law of averages — suggest the U.S. experience in the future might not be as positive as it was last century.

If these projections — based on the international experience — were to stand alone, they would be warning enough to avoid counting on stocks to outperform bonds over 20-year periods. But we have more compelling fodder to add to the mix.

Most observers are forecasting the equity-risk premium — the degree to which they expect stocks to outperform bonds — will fall to 3 percent in the future compared with the 7 percent average maintained over the last 50 years.

With a 7 percent equity-risk premium, you would expect stocks to outperform bonds in 92 percent of 20-year periods. But with a 3 percent premium, the chances of that happening fall to 65 percent.

Such a possibility is in line with Russell Investment's current projections, based on a variety of studies and forecast models, which predict that U.S. stocks will outperform U.S. intermediate government bonds by between 50 percent and 55 percent of one-year periods, between 55 percent and 60 percent of five-year periods, a little more than 60 percent of 10-year periods and around 65 percent of 20-year periods.

Further, the chances that stocks will outperform bonds increase over time, and viewed over 100-year periods stocks have a good chance of outperforming bonds. But such a long time frame is impractical for most investment horizons.

Looked at one way, those figures can give an investor confidence that in 6.5 out of 10 cases, stocks will outperform bonds over a 20-year time frame. But looked at another way these projections indicate a 35 percent chance of stocks performing worse than bonds — sometimes by a substantial margin.

Together, these predictions and an expanded historical perspective point to a time that could see stocks performing less strongly than we had expected. They lead us to believe that over the next 60 years, bonds will likely outperform stocks in one of the three 20-year periods. What we do not know is which of the 20-year periods it will be. It could be the 20-year period that has already begun.

Of course, such projections smooth over events like the bull market that peaked in 2000 and the subsequent bear market and look at the performance over the 20-year span, not at the individual years.

These observations force us in the direction of one conclusion: It is highly unlikely that long-term U.S. stock returns will exceed bond returns as frequently as they did last century.

If, therefore, you rely on a casual analysis of U.S. stocks over the last 100 years to suggest that stocks always outperform bonds over 20 years, and advise your clients accordingly, you may be setting them — and yourself — up for disappointment.

Robin Penfold is a consultant at Russell Investment Group

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