This Is Why Stocks Have Higher Returns Than Bonds
With the dramatic movement in the stock market recently, some of you may be asking yourselves “Why would I ever invest in stocks if they can fall 35% in a month?” From our perspective, this is exactly why you invest in them. We’ll explain.
Understanding Risk
In the financial markets, risk is typically defined as volatility, or how much the price of a stock or bond jumps around from day-to-day or year-to-year. If an investment moves around more (has higher volatility), it’s harder to own. This is because there’s less certainty about what will happen to its price over a given time period and it’s more difficult to hold onto the investment during periods when its price is falling. Many of you have no doubt experienced this firsthand over the past month or so. This is the human element of investing, where it’s natural to have an emotional reaction when you see your account values falling, especially in such a short amount of time.
Stocks Are More Volatile Than Bonds
The higher volatility of stocks relative to bonds is due to the nature of the two types of investments. When you buy stocks, you’re buying ownership in companies (albeit a small share). When you buy bonds, you’re lending money, either to companies or to governments. Because creditors are paid before owners, it’s riskier to own a company than it is to lend money, so the prices of stocks are more sensitive to changes in the economy.
To put things in perspective, if you look at market history going back to the Great Depression, you’ll see that stocks (based on standard deviation) have been more than four times as volatile as bonds have been. Year-to-year, stock prices move much more dramatically than bond prices. Said differently, a bad day for stocks is like a bad month for bonds.
Which Is Why Stocks Have Better Returns
With investing, there’s no free lunch and there tends to be a positive correlation between risk and reward. The flipside of stocks’ higher volatility is that they have also had much higher long-term investment returns than bonds. Over the same time period going back to the Great Depression, stocks (S&P 500) have had an average annual return of around 10%, compared to around 5% for bonds (U.S. 5-Year Government Bonds). The higher returns for stocks are the investor’s compensation for bearing their higher risk, or volatility.
And the difference in returns is dramatic, especially when extrapolated over many years. For example, if you invested $10,000 each in stocks and bonds today, and over the next 30 years your stocks earned a 10% annual return and your bonds earned a 5% annual return, at the end of the period your stocks would be worth more than four times as much as your bonds ($174,494 compared to $43,219).
The Importance of Matching Your Investments to Your Goals
All of this is also a good reminder of why it’s so important to match your investment allocation (mix of stocks and bonds) to your specific goals. If you have a goal, such as a down payment in a year, where you can’t afford for your investments to temporarily be down 35% or more, that money shouldn’t be invested in all stocks. On the other hand, the longer your time horizon, the better your ability to weather these periods of volatility and capture the better expected returns of stocks.
The Supermarket Analogy
When it comes to owning stocks, the best period to buy them is typically when it feels the worst to do it. Because of the emotions involved, stocks are one of the few things in the world that people tend to want to buy more of after their price has gone up but buy less of after their price has gone down.
Imagine you buy apples every month. Last month when you went to the store, they were $1 each. Today, you go to the store and you see that they’re now on sale for $0.65 – would you be inclined to buy more or less of them now? What about if their price had gone up to $1.50 instead? Looking at stocks in this context makes it easier to keep an unemotional perspective.
Conclusion
Periods like the current one are a dramatic reminder of why stocks have historically produced the attractive investment returns they have. Times like these are the admission ticket for the better returns of stocks. While staying the course is easy when times are good, it’s a lot more difficult during volatile periods like this. We all want the best of both worlds with the returns of stocks and the stability of bonds, but that’s like asking for dessert without the calories and, unfortunately, that’s just not how financial markets work. Remember that patient, disciplined investors who are willing to look past the uncertainty of the next day, month, or year have historically been rewarded.
About MD Wealth Management: We are an Ann Arbor financial planner that specializes in providing financial planning for physicians and retirees. We are CERTIFIED FINANCIAL PLANNER™ professionals and fiduciary financial advisors who operate on a fee-only basis, which means we do not sell financial products or collect commissions. As an Ann Arbor financial advisor, we enjoy working with clients both locally and remotely.