We tend to look at investment returns one year at a time. Most investment models treat each year’s returns as independent of previous years. But this isn’t actually true. A decade of returns in the real world doesn’t look the same as 10 independent single years strung together. Here I look at 10- and 20-year returns of different stock/bond mixes based on historical data.
As usual, it is easiest to get U.S. returns data. I found S&P 500 returns and 10-year Treasury bond returns from 1928 to 2013 at NYU Stern. I got historical CPI figures from Robert Shiller. This gave me 86 years of U.S. stock and bond real (inflation-adjusted) returns.
From these returns I created 5 portfolios with different stock/bond mixes: 0/100, 25/75, 50/50, 75/25, and 100/0. With the mixed portfolios, I rebalanced to the target percentages once per year. Then I calculated rolling 10- and 20-year returns. For each period, I calculated the compounded average annual real return.
Everything I’ve described so far is fairly standard, but the next bit isn’t. I took the 77 rolling 10-year annual returns and sorted them from lowest return to highest. I did the same for the 67 rolling 20-year periods. I did this independently for each of the 5 portfolio mixes.
This allows us to compare the worst outcomes for each portfolio against each other. These worst cases for the 5 different stock/bond mixes didn’t necessarily occur during the same time periods. We can also compare the best outcomes and everything in between.
Here are the results for 10-year periods:
Comparing the all stock portfolio to the all bond portfolio, it’s hard to see any reason to choose bonds. One might like the look of the 75% stock portfolio because in the bottom one-third of outcomes it looks better than the 100% stock portfolio, and isn’t too much worse for the top two-thirds of cases. It’s hard to see much justification for any of the portfolios with 50% or more bonds.
Here are the results for 20-year periods:
In this case it’s hard to make a case for anything but the all-stock portfolio over a 20-year period. More than half the time stocks beat even the very best bond return. It’s interesting to note that there isn’t much difference in slopes among the portfolios. The slope roughly corresponds to volatility. We’re used to thinking that stocks are much more volatile than bonds, but this isn’t true for 20-year periods.
The only remaining justifications I can see for having bond allocations for very long periods are related to behavioural problems and investing skill. By behavioural problems I mean that many people can’t stay invested in a volatile portfolio for 20 years without selling at a bad time. This is a real problem. I think people should try to educate themselves as much as possible to avoid such problems, but in the end, most people need bonds for a feeling of safety.
The other justification is investing skill. An investor who believes he or she can pick above-average bonds or bond funds will have reason to own bonds over the long run. Of course, the vast majority of such confident people are wrong and will get worse results due to following their own ideas. But there will be some who get good results by luck and possibly some who have genuine skill.
For the rational investor who is neither skittish nor overconfident, how should we use these results? I look at my own portfolio as made up of different investment horizons. I will spend some of my money the first year I retire. I’ll spend another slice the next year, and so on.
Each slice of my portfolio needs a different allocation. Only by adding up all of these individual allocations do I obtain my overall portfolio split between stocks and fixed income. The result is a heavy overall allocation to stocks, even when I first enter retirement. Because I managed to stay invested through the 2000-2001 crash of the tech bubble and the 2008 financial crisis, I have some confidence that I won’t sell at a bad time in the future. So, I can reasonably focus on returns over 10 or 20 years rather than single-year returns.
For investors who can stay calm through short-term fluctuations in stock prices, I still can’t see much justification in owning bonds in a portion of portfolios that they won’t touch for 10 or more years.