Equities v Bonds

Some interesting research by Rob Arnott of Research Affiliates is published in the Journal of Indexes.

Arnott has compared the relative performance of equity and bond indices over the long term (as reported by John Authers in the FT). The research relates to US data and shows that at the end of last week the S&P 500 index (a more relevant index than the Dow Jones) had fallen by 64.4% in real terms from its peak in 2000. Arnott goes on to say that this has happened only three times in US history and can probably be expected to happen only once or at the most twice in a life time. The previous instances that Arnott has identified were from 1929-1932 when the fall in real terms was 83%; between 1852-1857 the index fell 66% in real terms and from 1905-1921 it fell 65% in real terms.

So, the 2008/09 falls are approaching those seen in the great crash of the 1930s.

Arnott compares the equity index against the index for treasury bonds and concludes that equities in the US have now under performed treasury bonds since 1969.

There may be some flaws here. The first concerns income; this research refers only to index levels. Both bonds and equities produce income and although the income from equities is generally lower than the income from bonds (although the reverse is true from time to time, as at the moment) the income from dividends generally rises with inflation, providing a significant boost to total returns. Bond income by definition is fixed and in an inflationary environment bond income loses its value in real terms.

Second, equities as an asset class are a higher risk than bonds. At its simplest, bonds get paid out in the event of a failure of a company before equity holders who are usually the last in line. Logic dictates that equities will produce a better return than bonds over the medium to longer term, simply because otherwise investors would not take the risk of investing in equities without the potential for markedly better returns than bonds.

Finally, it is worth remembering that an index is an average, albeit a weighted average in many cases. An index therefore is composed of the best performers and the worst performers. In addition, equities exhibit markedly higher volatility than bonds and in some instances can completely fail in the event the company goes bankrupt whilst the bond holders may still receive something. This volatility can extend into long term cycles of devaluation and revaluation as mentioned in our earlier post. If we start bringing in the basic principles of investment management, namely asset allocation and an element of stock selection (ie some degree of management to take advantage of undervalued assets) then the exposure to equities should substantially outperform any exposure to bonds over the medium to longer term.