I’m very excited about the start of the football season (Go Blue!) and keep catching myself thinking of investments in football terms. The basic financial wisdom has it that stocks are great at putting up “points” over time but can be very volatile and hard to stomach (Team Offense). Bonds, on the other hand, are steady Eddie of investments and offer decent returns with much smoother ride (Team Defense). Another key benefit of combining both of them in the same portfolio is that bonds tend to zig when stocks zag thus providing a valuable diversification benefit. So let’s compare stocks with bonds and how they act relative to each other (see boring notes below about methodology).
Exhibit 1 shows some stats for stocks, bonds and a 50/50 mix of the two. Stocks had double the return but also double the volatility of bonds. Both stocks and bonds have had same number of negative years (15), thus about 80% of the annual returns are positive. 50/50 mix showed some diversification benefit with only 12 negative years (17%). For stocks the good years were really good while the bad ones hurt a lot, including almost 37% drop in 2008. The worst bond year was 11% drop in 2009 (albeit preceded by a 20% rise the year before in the flight to safety during the GFC). The 50/50 portfolio was quite appealing – providing 78% of the stock return with only 55% of the volatility.
Exhibit 1 – Stock and Bond Stats 1950-2019 (as of 9/10/19)
Looking at stocks’ 11.2% annual return versus 5.5% for bonds in a table doesn’t quite do it justice as compounding benefits are really huge over 70 years (Exhibit 2). Even if we just look at the last 30 years, stocks are clearly much better Team Offense, although 50/50 is not looking bad either.
Exhibit 2 – Cumulative Returns
Now let’s take a closer look at the interplay of the two asset classes. Out of the last 70 years, stocks and bonds were both positive in 42 years or 60% of the time (Exhibit 3). One or the other was negative 37% of the time. But for both of them to be negative was very rare indeed with only 2 years or 3% of the time. And one of them (2018) was just barely negative at -0.02%. So far so good.
Exhibit 3 – Positive and Negative Years for Stocks & Bonds (1950-2019)
Digging deeper I broke down the negative years (Exhibit 4). Of the 15 down years for stocks some were manageable while others hurt a lot; the average decline was almost -12%. However, bonds offset some of the stock drops in 13 of those 15 years (87%) with average return of +6.2%. In fact, in some of the worst years for stocks (2008 and 2002) bonds benefited from flight to safety and posted very attractive returns. The 50/50 portfolio declined 11 or the 15 years for a still unpleasant 73%, but the average decline was much more manageable 2.8% – a full 9% better than all-stock portfolio. And the worst year was -12% in 1974 compared to -36.5% for stocks in 2008.
On the flip side, when bonds have bad years (also 15 with average drop of 4%), stocks tend to do well posting 17% average gain. The 50/50 portfolio went up by 6.5% on average in those years. And while it’s no fun to see both stocks and bonds decline in the same year, it only happened twice in 70 years and the 50/50 returns weren’t so horrible with -4.4%.
Exhibit 4 – Breakdown of Negative Years (1950-2019)
Ben Carlson had a nice post with similar analysis and more eloquent description of diversification benefits. You can find more information on the bond market composition in this post.
So stocks are (or at least have been) better at putting up “points” like a high-powered football offense, but akin to a pass-happy teams they also provide many heart-stopping moments for investors. Bonds, like defensive squads, can score some points but generally their main benefit is allowing the offense to take calculated risks in order to win games (achieve investors’ long-term goals).
Another takeaway is that like good football teams investors need to pay attention to both sides of the ball to improve their outcomes. Mixing in some bonds in the portfolio might reduce long-term returns but if that’s what it takes to stay invested during volatile periods it’s well worth it in the long run.
I’m using S&P 500 as a proxy for stocks and 10-Year Treasury as a proxy for bonds. I have the data going back to 1928 but let’s just look at 1950 forward. The 30’s and 40’s were very unusual between the Great Depression and World War II, so post war period is more representative. Besides, the conclusions of the analysis remain the same, there is just more data to muddle through.
I chose to not include inflation in this analysis to keep it simple. With inflation there would be more negative years all around but the main conclusions would remain the same: stocks do better but with more occasional pain.