Stocks for the Long Run? Really?

Most of us have heard that stocks have outperformed bonds in the long run. But what is the definition of long run? So far this century, have stocks really outperformed?

To answer that question, I decided to look at how three different asset classes have performed in the new millennium. I examined the performance of stocks vs. bonds from Dec. 31, 1999 through June 30, 2015. I compared the total returns of U.S. stocks, international stocks and investment grade U.S. bonds. Total return includes reinvestment of all dividends and interest, something which is easy for investors to set up on an automated basis.

I used three different Vanguard funds to track the returns since Vanguard index funds have been around for the longest time. Specifically, the three funds I used were the Vanguard Total Stock Index Fund ( VTSMX), the Vanguard Total International Stock Index Fund ( VGTSX) and the Vanguard Total Bond Index Fund ( VBMFX).

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So far this century, bonds have beaten U.S. stocks and they've clobbered international stocks. Take a look:

• Vanguard Total Bond Index Fund (VBMFX): 121.7 percent.
• Vanguard Total Stock Index Fund (VTSMX): 104.1 percent.
• Vanguard Total International Stock Index Fund (VGTSX): 66.8 percent.

However, the total returns are only part of the story. As seen in the chart below, bonds were by far the least volatile of the three investments yet they had the highest return. International stocks were just the opposite, being the most volatile yet having the lowest return.

What This Means

It would be wrong to conclude that this provides much predictive value for the future. While picking the beginning of the century to track performance may not appear arbitrary, it is. If I had instead decided to look at the 20 years ending June 30, 2015, stocks would have outperformed. And that's because starting at the beginning of this century captured all of the bursting of the tech bubble with virtually none of the upside that preceded it. Further, the chart above captured two strong bear markets as well as an extraordinarily long period of declining interest rates, which increases the value of bonds.

Three Lessons Learned

I’ve always told people I’m a lot better at predicting the past than the future. Still, it's the past that holds some lessons for the future. First, the term “long run” can last a very long period of time. So far, it will be over 15.5 years in the context that stocks will have beaten bonds. If you are a long-term investor, you must understand and be willing to accept that stocks can underperform bonds for two decades or longer.

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Second, though each asset class has trounced the others over a period of several years, neither good times nor bad last forever in any asset class. Avoid the all too human urge to buy the hot asset class after it surges as many investors did by pouring into stocks (especially international) in 2007 only to flee to cash in 2008. After six years of a bull stock market today, you may have a false sense of how much risk you think you can take. In fact, even though stocks significantly underperformed bonds this century, having 30 percent of your portfolio in stocks (20 percent U.S. and 10 percent international) actually boosted total performance if one committed to regularly rebalancing  stocks and bonds to the 30-70 percent targets.

Third, whether stocks will beat bonds over the next decade is less a concern than how much more stable bonds are than stocks. Keep high quality investment grade bonds as your portfolio’s shock absorber. Notice in the chart above how the high quality bond fund continued to increase in 2008 as stocks plunged. This fund of investment grade bonds increased 5.1 percent in 2008, while the average bond fund lost about 8.0 percent, according to Chicago based Morningstar. Many bond funds lost a third of their value or more that year. Keep your bonds boring and understand the role they play in your portfolio.

Featured image: Ugerhan/iStock, Graph, Wealth Logic, data from Yahoo Finance

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