How Do Stock and Bond Performance Compare Over Time?
Looking at returns relative to risk helps to balance your portfolio
No matter what your goals are as an investor, retirement saving, income, college planning, or anything else, one of the most critical decisions that you have to make is where to put your money. The two most common investments for beginners are stocks and bonds. How do you decide what to buy?
One way is to look at how stock and bond performance compares over time. The chart below shows annual returns of stocks represented by the S&P 500, and Baa-rated corporate bonds since 1928.
The years that stocks outperformed bonds are in blue, and the years bonds outperformed stocks are in orange. The chart is an ocean of blue. It would seem that investing in stocks is an easy choice, why would anyone invest in bonds? As it turns out, performance is only one measure for successful investing.
Are Annual Returns a Good Measure?
How you invest has a lot to do with how much time you have before you need the money. If you are in the early to middle part of your career and you are investing for retirement, your time horizon is probably more than 10 years. On the other hand, if you are an active trader, you are looking for profits in a matter of days or weeks.
The next chart shows rolling 10-year returns from 1938-2019 for the performance of stocks versus bonds. Rolling 10-year returns for each year represent the annualized return for the previous 10 years. For example, 1950 represents the 10-year annualized return from 1940 to 1950.
Notice the difference: Looking at 10-year results, they are "smoother" than annual results, and bonds look more attractive. Also notice that the only negative years for stocks during any of the 80 rolling 10-year periods are 1938 through 1940, which reflect the lingering impact of the Great Depression. There are 19 individual negative years for stocks in the same period of time, by comparison.
This also illustrates how balancing your stockholdings with some stability from bond ownership in a portfolio can provide a hedge for potentially volatile swings in stock prices.
How Much Risk Can You Tolerate?
There's more to your investment decisions than just performance. How much risk are you willing to take? The 2020 financial roller coaster is a case in point. It took only about four weeks for the market to lose 32% of its value, plunging from the S&P record high of 3,358 points on Feb. 12 to 2,447 at the close on March 18, with wild swings along the way. The good news is that the S&P had recovered nearly all its losses as of mid-August.
If your time frame is short, or volatile markets like we have seen in 2020 keep you up at night, you have to consider that in your decisions.
The fact is that the average retail investor consistently underperforms the market, especially when the markets are unstable.
Measuring Risk and Return
Two common ways to measure the risk of an investment are beta and standard deviation. Beta measures an investment’s sensitivity to market movements, its risk relative to the entire market. A beta greater than 1 means the investment is more volatile than the entire market. A beta of less than 1 means the investment is less volatile than the market.
Standard deviation measures the volatility of the investment. A lower standard deviation means more consistent returns. Higher standard deviation means less-consistent returns, translating into more risk. The chart below shows an example of the beta, standard deviation, and returns for an S&P 500 index fund, a bond index fund, and a fund that invests strictly in smaller companies.
|Beta||Standard Deviation||3-Yr Return|
|S&P 500 Index Fund||1||16.95||10.71%|
|U.S. Bond Fund Index Fund||1||3.32||5.23%|
|U.S. Small Cap Fund||1.17||27.69||12.5%|
Notice that the beta for the S&P index fund and the bond index fund is 1. That's because those funds represent each broad market for stocks and bonds. Also notice the beta for the small-capitalization fund is 1.17, which indicates that this fund is more volatile than the broad market represented by its benchmark, the Russell 2000 growth.
No surprises here, the bond fund has a much lower standard deviation, less risk, and offers less return.
How the Sharpe Ratio Can Help You Value Risk
How do you determine if you're being paid fairly for the risk that you are taking with an investment? There is a measure, called the Sharpe ratio, which compares the standard deviation against the returns. If an investment has high volatility with low returns, the Sharpe ratio will reflect that. A Sharpe ratio of 1 or more is the goal. Here are the Sharpe ratios for the S&P index fund, the bond fund, and a fund that invests only in large-cap growth companies.
|Sharpe Ratio||3-Yr Return|
|S&P 500 Index Fund||0.53||10.71%|
|U.S. Bond Index Fund||1.11||5.23%|
|U.S. Growth Fund||1.24||26.94%|
Notice the Sharpe ratio for the S&P 500 index fund versus the growth fund and bond index fund. The S&P 500 index fund is not rewarding you relative to the risk that you are taking as well as the growth and bond index funds are.
How to Use Asset Allocation
Asset allocation is the process of deciding how much of your money you should put into stocks, bonds, cash, and perhaps other investments like real estate or commodities to achieve the best return for your risk tolerance.
Whether you are by nature a conservative investor or someone who wants to roll the dice, the "big idea" behind managing your investments is to get the best return for the risk that you are willing to take.
Broker-dealers like T.D. Ameritrade and mutual fund companies such as T. Rowe Price and Fidelity, along with others, offer model portfolio products with pre-determined allocations. Allocation models are typically billed as conservative, moderate, or aggressive. These prepackaged funds are an easy way for investors to create portfolios aligned with their time frames and risk profile.
The Bottom Line
Using tools like standard deviation, beta, Sharpe ratios, and illustrations like rolling 10-year returns can help any investor make smarter decisions about their portfolio and seek the best return for the risk they are willing to take.
The average retail investor consistently underperforms the market. They make less in the good years, and lose more in the bad years. But you don’t have to be the average investor. Be honest with yourself about how much risk is comfortable for you. Don't chase returns, and unless you're an active trader, take a longer view.
If you are new to investing, or don't have the time to do your own research, consider working with a professional financial adviser.
The Balance does not provide tax, investment, or financial services, and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.