Given the poor performance of stocks over the past year and the past decade, there has been ample discussion about the relative performance of stocks versus bonds. Some even argue that investors should allocate entirely to bonds, not only because bonds are the safer investment, but also because they believe bonds will outperform stocks over the long run. In other words, if bonds can deliver higher returns with less risk, why bother with stocks?

Table 1: Compound Annualized Total Returns Ended June 2009 (%)

If one looks at the returns over the past 40 years, the argument that bonds might outperform stocks seems valid. But one should view this argument with skepticism. First, note that over the 20-, 30-, and 40-year periods, stocks actually performed quite well, even if some bond categories did better. Over the very long term, it is no longer a contest. Chart 1 gives the results of the capital market returns over the past 83 years. During this longer period, stocks easily beat bonds.

Chart 1: Ibbotson SBBI Chart: Stocks, Bonds, Bills, and Inflation 1926–2008¹
Source: Ibbotson.

Table 2 looks at a longer history of U.S. stocks. The returns on the stock market have been consistently high over almost two centuries. The returns over the past 40 years are roughly comparable to the more distant returns.

Table 2: Annualized Compounded Total Returns (%)²

Source: Ibbotson.

A long-term history provides two major insights:

1. Stocks have outperformed bonds.
2. Stock returns are far more volatile than bond returns and are thus more risky. Given the additional amount of risk, it is not surprising that stocks don’t outperform bonds over every period — even over extended periods.

Stocks vs. Bonds in the Future
How likely are stocks to outperform bonds in the future? To try to figure out the future, let us look in more detail at what happened during the past 40 years.

Chart 2: Historical Returns Decomposition over the Past 40 Years (July 1969–June 2009) Source: Ibbotson. *The BarCap/LB US Aggregate Bond Index goes back only to January 1976.

Despite the substantial decline in yields over the past 40 years, Chart 2 shows that the bulk of the bond returns came from the income return portion, or yield. On average, the bond income return from coupon payments was more than 7 percent. Capital gains caused by the yield decline made up the additional return.

Table 3: Bond Yield (%)

To analyze which asset class is more likely to outperform in the future, let’s take a deeper look at the historical data and the current market environment. We analyze each component of future returns for stocks and bonds as follows:

Bond returns = Current yield + Capital gains
Stock returns = Current yield + Earnings growth + P/E changes

First, given the current low-yield environment, it would be almost impossible for bonds to generate the same amount of capital gains as they did in the past. In fact, a reasonable estimate might be that there will be no more capital gains in the future because yields may be at least as likely to rise as to fall.³ Absent any future fall in yields, all of the return would have to come from the coupon return. That means the total returns for bond investments would likely be between 3 and 4 percent.

For stocks, the annualized dividend yield from January to July 2009 for the S&P 500 was 2.59 percent. If stocks produce more than 2 percent in capital gains per year, on average, they will likely beat bonds. Stock capital gains can be decomposed into nominal earnings growth and changes in the P/E ratio.⁴ Historically, U.S. long-term nominal earnings growth has been roughly 5 percent, which is comparable to the nominal GDP growth. If we assume that the market valuation level (operating P/E of S&P 500) stays at the same level over the next 40 years, then we would have an equity return of around 7 percent. Even if we forecasted a decline in the valuation level, the 10-year average P/E level would need to fall from just about 20 to below 5 to get equity returns around 3 percent.

Conclusion
Bonds have not only outperformed stocks by a large margin over the past year because of the financial crisis, but they have also roughly matched stocks over the past 40 years. This historical trend begs the question, will bonds continue to outperform stocks?

Upon closer examination, on the one hand, we show that stock returns over the past 40 years were virtually in line with the long-term historical average. On the other hand, bond returns were not only much higher than their historical averages but were also higher than their current yields. This high bond return is due to higher interest rates in the 1970s and a subsequent declining-interest-rate environment. This scenario for bonds is very unlikely to repeat in the future, given today’s low-interest-rate environment. Investors who hope bonds will outperform stocks in the coming years will likely be disappointed.

Stocks tend to outperform bonds over time but are much more risky, even over longer periods. Bonds can outperform stocks over a long period, but investors need almost perfect timing to get in and out of the market to realize such returns. We believe the right strategy is to follow a disciplined asset allocation policy that considers the return and risk trade-offs by taking advantage of the diversification benefits of stocks and bonds over time.

As Warren Buffett wrote in his 2009 annual shareholder letter:
 
When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.

Roger Ibbotson, PhD is founder and advisor for Ibbotson Associates, a Morningstar Company.

Peng Chen, PhD, CFA is president of Ibbotson Associates, a Morningstar Company.