This is the primary in a series of articles difficult the traditional wisdom that stocks all the time outperform bonds over the long run and that a negative correlation between bonds and stocks results in effective diversification. In it, Edward McQuarrie draws on his research analyzing U.S. stock and bond records dating back to 1792.
When I tell acquaintances that I even have compiled the historical records of the performance of stocks and bonds going back to 1792, their first response is frequently: “200 years ago, I didn’t know stocks and bonds existed!”
You do not know Jeremy Siegel’s book: “Stocks in the long runwhich is now in its sixth 12 monthsTh Edition through which he presents a 200-year series of stock and bond returns that he first compiled 30 years ago.
The book conveys an easy message with compelling support from this story. That is, stocks have all the time made buy-and-hold investors wealthy, and the wealth creation possible with stocks far exceeds that of any alternative, akin to bonds.
My latest research: “Stocks in the long term? Sometimes yes sometimes no” published in suggests otherwise. I’ll begin to elucidate these ends in this text. But first, a reminder of the theoretical support that underpins Siegel’s “Stocks for the Long Run” thesis.
Risk and return
Bonds, particularly government bonds, are “fixed income” assets. Investors receive the coupon and return on capital at maturity. No less, but no more. The risk is minimal and the promised return is correspondingly low since it is basically secured.
Stocks are risk investments. No guarantees. Your investment could go to zero.
In particular, investors are risk-averse. No utility maximizer would put a penny into stocks without promising upside potential, i.e.
Therefore, stocks may be expected to outperform bonds over an extended time period after short-term fluctuations subside, just as Siegel’s story shows.
The riddle
If stocks are sure to outperform bonds over a period of, say, 20 years or longer, then where is the danger?
And if stocks pose no risk over long periods of time, why should their returns exceed the returns of bonds, which pose no risk?
The logic behind “stocks for the long term” is blown away. The theory states: “Expected return is a positive function of risk.”
However, Siegel history shows no risk in holding stocks for long periods of time. The stock investor all the time wins.
The resolution
I call it a puzzle, not a paradox, since it is straightforward to resolve. All that is required is evidence that stocks sometimes explode, no matter holding period, leading to underperformance either in absolute terms or relative to bonds.
Most of the time, stocks can win over arbitrarily long intervals while losing over arbitrarily long intervals. These occasional deficiencies are enough to revive risk.
And risk is essential to any reasonable expectation of delivering excess return over a Treasury benchmark.
I discovered these flaws within the historical records I compiled.
The updated historical record
My article accommodates a summary of how I compiled the historical data. The online appendix goes into more detail and includes the raw data if you wish to experiment with it.
Here is a chart depicting the updated historical data set:
What do you see?
- For almost 150 years, stocks and bonds produced in regards to the same wealth. It was a horse race with the lead swinging backwards and forwards. Occasionally stock prices rose, as within the Twenties, but occasionally they fell, as within the a long time before the Civil War. On the entire, the image is one in every of equivalent performance until the Second World War.
- Then, during and after the war, wealth boundaries diverge dramatically. In the 4 a long time from 1942 to 1981, stocks built an enormous lead over bonds. The stock investor would have turned $10,000 right into a real $136,900. The bond investor would have lost money and turned $10,000 right into a real $4,060.
Think about it for a moment: you’ll have lost money with “safe” government bonds. After the war, bonds proved to be a dangerous investment.
Here, too, the shares performed extremely well after the Second World War. If you mentally draw a straight line from the beginning of the stock line in 1792 to its end in 2019 (this chart ends before the pandemic), there will not be much deviation within the second chart. There was a slight upward movement until about 1966, however the inflation of the Seventies and the bear market of 1973-1974 brought stocks back into trend.
Rather, bonds performed exceptionally poorly during this era. Nowhere else within the chart is there a decade-long period of steadily declining bond assets. The a long time leading as much as World War I come closest, however the decline was abrupt and temporary – nothing in comparison with the a long time of impotence that followed World War II.
The third panel represents my innovation in chart design. In a standard multi-century chart, the human eye cannot tell whether parity performance has been restored once the wealth lines diverge, as in the center panel. In a seal-style diagram (see p. 28 in 6Th Edition of “Stocks for the Long Run” or p. 82 within the fifthTh issue), what you see is a spot in stock and bond performance that appears to persist to this present day. In order to see the return to parity performance after 1981, it’s vital to reset the bond asset limit to the 1981 equity limit. Once this has happened, the virtually equal performance of the next 4 a long time will change into visible.
The title of my work is: “Stocks in the long term? Sometimes yes. Sometimes no,” this table summarizes.
How bad can it get?
The Panic of 1837 was the second-worst investor disaster in all of US history, surpassed only by the Crash of 1929 and the following global economic crisis. The Panic of 1837 was measurably worse than the panics of 1819, 1857, 1873, 1893, 1907, and even the mini-crash of 1921.
The largest single holding in 1840 was the Second Bank of the United States
(BUS). It accounted for about as much of the full market cap as that Magnificent Seven Today. It failed spectacularly, the value plummeted from $120 to $1.50 and never recovered.
Stock returns over several a long time spanning the 1840s and 1850s are subsequently among the many worst in U.S. history, with the biggest stock deficits.
Unfortunately, missing from Siegel’s data sources were the Second BUS and other banks that collapsed within the Panic of 1837, in addition to the turnpikes, canals, and railroads of the nineteenth centuryTh Century that either went bankrupt or never paid a dividend.
In other words, the bad things were ignored. My data collection found these poor returns and added them back to the information set.
Objection?
“Fascinating historical research, Professor. But I have a hard time seeing the relevance of a stock decline 200 years ago to investing today. “So much has changed,” is the standard response to my research results.
I’ll answer in my next post.
Photo credit: ©Getty Images / Rudenkoi
