Classic Bernstein 4 — Stocks Always Beat Bonds?

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Classic Bernstein 4 — Stocks Always Beat Bonds?

Post by SimpleGift »

PREFACE: This is the fourth in a series of posts highlighting the classic investing insights of William Bernstein from the 1990s and early 2000s. Many new Bogleheads have never been exposed to his early writings — and while the data sets used may seem antiquated, his portfolio concepts and novel analyses are still helpful to investors today, new and old alike.

Previous topics in the series: 1-Asset Allocation & Time Horizon, 2-Choosing Portfolio Bond Duration, 3-Diversifying Portfolio Equities
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This post focuses on Mr. Bernstein’s early critique of professor Jeremy Siegel’s assertion that, over progressively longer time periods, the odds of stocks underperforming bonds and T-bills gradually decreases to zero. In other words, if held long enough, stocks always beat bonds. The long-term historical record has mostly supported this assertion, as stocks outperformed T-bills in 97% of the 30-year periods from 1802-1997 and in 100% of the 30-year periods from 1871-1997. According to Mr. Siegel:
Jeremey Siegel wrote:Although it might appear to be riskier to hold stocks than bonds, precisely the opposite is true. The safest long-term investment for the preservation of purchasing power has clearly been stocks, not bonds.
It’s Mr. Bernstein’s contention that the reason stocks have outperformed bonds so consistently over long periods is that their returns and their risk premium over bonds have been so very high — and, in the future, if the equity risk premium is somewhat smaller, and stocks do not best bonds by very much, then stocks still retain their significant long-term risk. Historically, over the 1802-1997 period, stocks’ risk premium over T-bills was 5.5%, and averaged 7% in the twentieth century. But what if, in a lower return future, the equity risk premium over T-bills is only 4% — or only 2%?

To test these hypotheticals, Mr. Bernstein created a model to calculate the theoretical probability that stocks will outperform T-bills (using the four inputs of historical stock and T-bill returns, the stock return standard deviation and time horizon). Plotted below on the left are the theoretical (in red) and the actual (in black) percentages of time that stocks have outperformed T-bills. The agreement between his model and actual history is quite good. Mr. Bernstein then calculated a range of possible equity risk premia and their theoretical consequences, which are plotted in red on the right.
His conclusions:
  • a) Once the equity risk premium falls below 4%, in addition to their breathtaking short-term volatility, stocks run a significant risk of underperforming T-bills, even if held for 30 years.

    b) Yes, the long-term risks of equities were lower than that of bonds and T-bills in the historical past. But the good news is already out about the stock market and totally discounted into its present price.

    c) Going forward, stocks will be riskier than bonds and T-bills, no matter how one measures it — and the rewards for bearing this risk will likely be lower.
Thoughts?
Last edited by SimpleGift on Sat May 28, 2016 8:17 pm, edited 1 time in total.
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Re: Classic Bernstein 4 — Stocks Always Beat Bonds?

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Just a personal postscript:

Obviously, no one can say for sure whether the equity risk premium (ERP) will be lower in the decades to come than it’s been in the historical past. Yet, among those researchers who ponder the equity risk premium, I don’t recall having read one who argues that the future ERP that will be greater than the historical averages.

The arguments for a lower ERP are varied — from declining earnings yields in recent decades (Siegel), to equity market survivorship bias in the historical data (Goetzmann), to a permanent ERP decline due to more stable and regulated equity markets (Cornell) — and only in hindsight we will know whether they are right. Yet the genuine possibility of an equity risk premium that is much lower in the future than in the past should give investors pause for thought.
  • Actual and Forecasted Equity Risk Premium, 1935-2014
    Image
    Source: Claude Erb
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Re: Classic Bernstein 4 — Stocks Always Beat Bonds?

Post by kenner »

My conclusion: Diversify.

There seems to be no rationale for bonds to outperform stock ownership over the very long run. Short term returns may certainly vary.

I do agree with Dr. Bernstein's opinions that, given current US and global economic conditions, equity returns may be muted.

No way to tell if that is a permanent condition. Permanency is doubtful.
Last edited by kenner on Sun May 08, 2016 3:14 am, edited 1 time in total.
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Re: Classic Bernstein 4 — Stocks Always Beat Bonds?

Post by lack_ey »

For what it's worth, Credit Suisse shows world equities in 1900-2015 outperforming US T-bills by 4.2%. Specifically, US equities by 5.6%, ex-US equities by 3.5%.

Overall I get a sense that investors overall are overconfident in equity returns for the long run. Not only is the historical data noisy and inconsistent, but It's hard to get a sense of how the future can differ from the past. I don't suggest hiding under the covers, but on the other hand some people act as if the probability of negative or lower-than-t-bills stock returns for a couple decades is basically zero outside of economic collapse and that the reason to hold anything other than stocks is behavioral. Just because the average or expected outcome is a certain way doesn't mean that it'll actually turn out anything close to expected.

kenner wrote:[...]There seems to be no rationale for bonds to outperform stock ownership over the very long run. Short term returns may certainly vary.[...]
What's shown is that if stocks have an expected return 4% over T-bills, they could well lose to them (about a 10% chance) over a given 30-year period, at least going by the analysis. That's not really short term.
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Re: Classic Bernstein 4 — Stocks Always Beat Bonds?

Post by kenner »

lack_ey wrote: What's shown is that if stocks have an expected return 4% over T-bills, they could well lose to them (about a 10% chance) over a given 30-year period, at least going by the analysis. That's not really short term.
Agreed. Historically, it does seem that bonds have occasionally outperformed stocks for decades at a time. Hence, the reason to diversify.

To me, it seems that we are in relatively uncharted economic times. But it is not clear how that alters market-driven risk premiums.
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Re: Classic Bernstein 4 — Stocks Always Beat Bonds?

Post by JoMoney »

Thoughts? From the copyright date, it looks like Dr.Bernstein posted that sometime in 2002, in the following 13 years stocks had a CAGR of about 9% (pretty close to their 'long run' return of 10%), vs 1.3% for Tbills

Over the most recent 30 year period stocks returned 10.5% vs 3.5% for Tbills

"...I strongly doubt that future stock returns are going to be 5.5% higher than T-bills, as they were from 1802 through 1997, or 7% higher than T-bills, as they were in this century. ..."

In the 18 years since 1997 stocks only returned about 6.2% and the return on T-bills was only 2.1%, right now it stands at about a 4.1% "premium", but if we're looking at 30 year horizons as mentioned throughout the post, we've got 12 more years to go, with T-bills yielding next to nothing, I think Siegel could have the Dr. Bernstein eating crow.
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Re: Classic Bernstein 4 — Stocks Always Beat Bonds?

Post by Wildebeest »

Thanks Simplegift for posting this series on William Bernstein's writings and I hope you keep the installments coming.

I like the update of JoMoney as to how Bernstein's projections played out in reality.

I think William Bernstein is right on by the numbers the ERP with of 4.1 % since 1997 and with the concensus future stock returns are expected to be lower in the next 20-30 years ( I doubt that one Year T bills will go negative in the USA).

I find William Bernstein's rationale, that over progressively longer time periods, the odds of stocks underperforming bonds and T-bills does not gradually decrease to zero, convincing.
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Re: Classic Bernstein 4 — Stocks Always Beat Bonds?

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lack_ey wrote:Overall I get a sense that investors are overconfident in equity returns for the long run...(snip)...some people act as if the probability of negative or lower-than-t-bills stock returns for a couple decades is basically zero outside of economic collapse and that the reason to hold anything other than stocks is behavioral.
kenner wrote:My conclusion: Diversify.
These are my takeaways from Mr. Bernstein’s analysis as well.

I’ve long suspected that modern-day investors have little appreciation for how just extraordinary the equity returns of the 20th century have been, especially in the United States. The combination of rapid population growth rates and high productivity growth led to an exceptionally favorable period for equity returns. (See this post.) And this is the very period from which we have drawn ALL of our historical return data for stocks and bonds!

It's nearly impossible for future global demographic and productivity growth to match that of the past. I’m not by any means expecting a disastrous future for equity returns — just one that’s much more muted than what we are used to from looking at the historical record. Should this be, Mr. Bernstein is pointing out that bonds are not just for behavioral insurance in the long-term investment portfolio, but could at times be a significant contributor to total return as well.

A bit of a paradigm shift for long-term investors?
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Re: Classic Bernstein 4 — Stocks Always Beat Bonds?

Post by bertilak »

Could it be that the few 30-year periods where bonds outperformed stocks were periods that started at the peak of a market boon? Perhaps with a simultaneous bottom in bond rates.

Of course such peaks are only apparent in hindsight. :(

Did any of those 30-year periods have negative returns?

Might rebalancing a mixed portfolio of stocks and bonds would smooth thing out.
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Re: Classic Bernstein 4 — Stocks Always Beat Bonds?

Post by nedsaid »

I read somewhere in Bernstein's Four Pillars of Investing that over very, very long periods of time that the returns of stocks and bonds are the same. He also said that as societies became wealthier and wealthier than investment returns dropped.
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Re: Classic Bernstein 4 — Stocks Always Beat Bonds?

Post by tludwig23 »

I think these extreme long term studies can be difficult to analyze (however interesting) for a number of reasons. Maybe the ERP is smaller now than it has historically been because it is so much easier for the individual investor to ensure she gets the ERP by buying a broad based mutual fund. Prior to 1924 there were no modern mutual funds and most investors held only a few individual stocks. Therefore they had a very real risk of choosing the wrong stocks and losing most of their money. I'm sure everyone (at least everyone in the investor class of society) knew someone who had "lost it all" in the stock market, perhaps increasing the perception of the equity risk and thus increasing the equity risk premium. Most of this period was before MPT, before efficient frontiers, and before many other bases of knowledge we have all incorporated into our psyches.

I think these types of studies have great heuristic value for discussion and research on topics such as, "What determines the ERP?", but are not very useful for the individual investor who is asking, "What percentage of my portfolio should be in bonds?"
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Re: Classic Bernstein 4 — Stocks Always Beat Bonds?

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JoMoney wrote:In the 18 years since 1997 stocks only returned about 6.2% and the return on T-bills was only 2.1%, right now it stands at about a 4.1% "premium", but if we're looking at 30 year horizons as mentioned throughout the post, we've got 12 more years to go, with T-bills yielding next to nothing, I think Siegel could have the Dr. Bernstein eating crow.
Point taken, JoMoney — but my sense is that the main thrust of Mr. Bernstein’s analysis was far beyond just the one 30-year period following its publication. We may not know for another 50 years whether the long-term decline in the equity risk premium is mostly permanent or just a transient trend of recent times — although it definitely seems unlikely that the ERP could match the historical averages going forward.

I get the impression Mr. Bernstein is gently prodding us to re-examine our thinking about the role of bonds in the long-term portfolio, especially in the face of lower expected equity returns in the decades ahead. If the future ERP is 5%, bonds will generally be a drag on long-term portfolio returns — but if the ERP is 3%, bonds will sometimes save the day, even over 30-year holding periods (in fact, about 20% of the time, according to Mr. Bernstein's model).
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Re: Classic Bernstein 4 — Stocks Always Beat Bonds?

Post by tludwig23 »

Simplegift wrote:...If the future ERP is 5%, bonds will generally be a drag on long-term portfolio returns — but if the ERP is 3%, bonds will sometimes save the day, even over 30-year holding periods (in fact, about 20% of the time, according to Mr. Bernstein's model).
And his model is based on one-year T-bills. The return on TBM is likely to be greater because of term and credit risk. If the ERP is 3% versus the "risk free" one year T-bill, the TSM vs. TBM premium is likely be much lower.
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Re: Classic Bernstein 4 — Stocks Always Beat Bonds?

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tludwig23 wrote:If the ERP is 3% versus the "risk free" one year T-bill, the TSM vs. TBM premium is likely be much lower.
Good observation. Among his collection of historical ERP charts, Mr. Erb has one that illustrates the realized ERP difference between intermediate bonds and T-bills. This spread looks to have generally increased over the past 80 years:
  • Realized Equity Risk Premiums, 1935-2014
    Image
    Source: Claude Erb
It’s interesting to see how different ERP researchers define the “risk free” rate. Many use T-bills, others insist on inflation-linked bonds, and some just use intermediate Treasuries. As you point out, it can make a big difference which rate is used in a particular analysis.
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Re: Classic Bernstein 4 — Stocks Always Beat Bonds?

Post by Bill Bernstein »

Well, it's been a while since 2002.

Estimated vs. T-bills, currently yielding, at best, 30-50 bp nominal, equities are priced to return, oh, say, 6.5% nominal (2% divs, 4.5% earnings growth) for an expected ERP of around 6%.

So I think it's now highly probable that stocks will beat bills over the long term.

Of course, returns have been so generous since 2002 that many have more assets than they deserve to, thanks to the same Fed policies that have reduced T-bill yields, so there's now less need to take that risk, at least if you've been saving and investing the past 20 years and are now running short of human capital.



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Re: Classic Bernstein 4 — Stocks Always Beat Bonds?

Post by siamond »

It appears that the charts in the first post assume that stock volatility will stay the same as in the past while the ERP would change (e.g. decrease). This doesn't seem like a reasonable assumption. This would actually seem to contradict the good old relation between risk and reward. This being said, I just took a look at Int'l returns and Std-deviation and ERP in the Triumph of the Optimists book, and this goes all over the place... :shock:

I would also observe that if we accept that we're in a world of low equity returns (say 5%), then one pretty much has to accept that we're in a world of low bonds return (say 1%) - using real numbers. Then ok, the ERP might be 4%, lower than historical, but what's an investor to do, then? I seriously doubt that most will flock to bonds with bare bone returns. One needs some growth, and if this requires additional risk, then we may not have much of a choice.

Finally, let's not forget that Pr Siegel's assertion (stocks beat bonds on the long term, at least so far) was clearly reinforced by the Triumph of the Optimists ground-breaking study, where the assertion remains true for nearly every possible country in the world, with a very diverse set of ERPs.

(side note: I finally bought my own copy of the Triumph of the Optimists book, can't wait to read it in details, I had only skimmed through it in a library so far).
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Re: Classic Bernstein 4 — Stocks Always Beat Bonds?

Post by Northern Flicker »

Are the current expected real returns of equities at historic lows, or is it just expected nominal returns?
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Re: Classic Bernstein 4 — Stocks Always Beat Bonds?

Post by LadyGeek »

A complete list of Simplegift's series is now in the wiki: Classic Bernstein
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Re: Classic Bernstein 4 — Stocks Always Beat Bonds?

Post by garlandwhizzer »

jalbert wrote:
Are the current expected real returns of equities at historic lows, or is it just expected nominal returns?
My understanding is that both nominal and real expected returns in the foreseeable future, say the next 5 - 10 years, will be lower than historical averages but not the historically lowest. As to the lowest expected nominal and real equity returns I think that dubious prize goes to the tech boom era. In 1999 the S&P 500 had a PE greater than 30 and a Shiller PE 10 greater than 40. At that time as I recall 10 year Treasuries were yielding about 6% or more and REITS were yielding about 9% and selling at or even below book value. Being both knowledgeable and brilliant, Bogle read that writing on the wall and shifted some assets from stocks into bonds at that point. In retrospect it seems like a no-brainer. At the time however, almost all investors were swept up in the "This time it's different" tune that dominated the financial media and investor psyche. Valuation disparities suggested that both bonds and REITS might well outperform stocks, at least the richly valued growth stocks, going forward for some years. That in fact did happen during the following decade or so.

The problem we face today is not just that stocks are by most measurements richly valued, but not bubble level, relative to expected future corporate profit growth (or lack of it). Bonds are also at or close to historically low yields. Likewise with REITS. Starting from here and now, all major asset classes in the US look richly valued presently and therefore the future expected returns on all these assets classes going forward are expected to be positive but significantly lower than the generous returns that past history has afforded us. Unlike the situation in 1999 there are no great alternatives like bonds or REITS in US markets that are expected to produce high levels of risk adjusted return over the next decade or so. International equities and especially EM have more appealing valuations presently but those asset classes also have considerably more volatility and risk.

What is an investor to now? For those of us who have a broadly diversified, very low cost portfolio dominated by indexes and with a combination of safe and risk assets aligned to our own risk tolerance, I suspect the answer is nothing. Stay right where you are be as patient as Job and stay invested for the long run. For those who don't have such a portfolio, the best answer may be to get one and keep it.

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Re: Classic Bernstein 4 — Stocks Always Beat Bonds?

Post by Artsdoctor »

Bill Bernstein wrote:Of course, returns have been so generous since 2002 that many have more assets than they deserve to, thanks to the same Fed policies that have reduced T-bill yields, so there's now less need to take that risk, at least if you've been saving and investing the past 20 years and are now running short of human capital.

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Well this certainly describes me!

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