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In our first foray into tracking stock and bond returns since 1934, we checked out nominal and real returns. Our goal was to find out whether investing in stocks and/or bonds at the moment produced higher or lower returns than not investing.
Next, we’ll take a look at how stock and bond returns relate to one another and to inflation. The correlation between stock and bond returns (see chart below) is kind of low, at just 0.073. I’ve included a trend line as a guide, but visually it’s difficult to see a pattern.
This low correlation implies that portfolios that contain each stocks and bonds enjoy a “diversification benefit.” For example, the expected return of a portfolio evenly split between stocks and bonds is the same as the common of the expected stock and bond returns, but the chance is lower than the common of the stock and bond risk. The return-to-risk ratio is higher than for portfolios consisting only of stocks or bonds, just as a portfolio that accommodates lots of stocks has an expected return equal to the common expected return of all stocks but less risk than the common risk of all stocks.
The correlation between stocks and bonds and inflation.
According to the Consumer Price Index (CPI), each stock and bond returns are negatively related to higher inflation. Purchasing power returns for bonds and stocks were lower when inflation was higher.
The connection between bonds and inflation.
Bond yields have a very strong negative relationship with inflation, with a correlation of -.408. Visually (see chart above), the pattern is kind of pronounced. The dots are clustered across the trend line.
In particular, if inflation comes as a surprise, we might expect real bond yields to fall as inflation rises. Bond rates are set in dollars. When dollars are price less, bond rates are also set in dollars. (Note that when inflation rates rise, we might not expect real TIPS yields to suffer in this fashion – TIPS rates are set in real terms.)
Stocks even have a negative correlation with inflation at -.229. The clustering across the trend line is less pronounced than with bonds.
The connection between stocks and inflation.
Some imagine that stocks provide a hedge against inflation. The proven fact that post-inflation stock returns tended to be lower during times of upper inflation suggests that stock returns (stock price increases and dividends) have been slow to vary to maintain pace with inflation.
To indicate that stocks function an efficient hedge against inflation, we would want to search for a much stronger and more positive relationship, similar to a correlation well above 0.5.
Frequency distribution of quarterly stock returns
The correlation charts also show that each stock and bond returns vary widely. In these views, the ranges for stocks and bonds seem like quite similar, with most quarterly returns starting from about -30% to plus 20%.
However, histograms (counting the frequency of returns of a certain percentage in the information) of quarterly returns (stocks on top and bonds on the underside) show that stock returns are way more variable (riskier!) than bond returns. Bond returns are likely to be more concentrated around zero than stock returns, and stock returns are more dispersed (very low and really high returns are more common) than bond returns.
Frequency distribution for quarterly long-term bond returns
How does this affect the consistency of returns over time?
For bonds, there have been long periods of (small) negative returns in the primary fifty years we study (highlighted within the orange ovals below).
5-year yields for 20-year bonds
Over the past forty years, yields on 20-year bonds have been less expensive, although the five years as much as 2013 and particularly the last five years (as much as 2023) have been disappointing.
Stocks have consistently had more positive (and better) real returns over the past ninety years.
S&P 500 5-year returns
Nevertheless, the true return was negative in each the ten years as much as 1978 and as much as 2008 (orange ovals within the graph above).
Both stocks and bonds produced positive real returns over the ninety years, but not every quarter (because the histograms showed) and never even every five- or ten-year period.
Investors needed patience (sometimes lots of patience!) to endure the difficult times of negative returns in the event that they were to benefit from the positive returns that eventually got here from each stocks and bonds.
How are you able to develop or maintain patience?
First, for those who understand the risks of your portfolio and its potential performance, you shall be less surprised and upset by the inevitable downtime.
Second, knowing how much risk you possibly can afford can provide you with the boldness it’s good to maintain your investment policy even during times of negative returns. (The risk you possibly can afford refers to what number of shares you possibly can hold in order that even a poor performance within the stock market doesn’t threaten your required way of life.)
Successful investing is a long-term activity. Patience will most definitely be rewarded. Unfortunately, because the charts we’ve checked out show, there are not any guarantees for either stocks or bonds!
The foregoing content reflects the opinion of Rick Miller and is subject to vary suddenly. The content provided here is for informational purposes only and mustn’t be used or construed as investment advice or a advice to purchase or sell any security. There isn’t any guarantee that any statements, opinions or forecasts provided here will prove to be accurate.
Past performance shouldn’t be necessarily indicative of future results. Indexes are usually not available for direct investment. Any investor attempting to copy the performance of an index will incur fees and expenses that reduce returns.
Investing in securities involves risks, including the chance of lack of principal. There isn’t any guarantee that any investment plan or strategy shall be successful.
