Jeremy Siegel: How Stocks Become Less Risky Than Bonds

The guru explains the shifting relationships among asset classes over time

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Dec 31, 2018
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In chapter six of his famous book, “Stocks for the Long Run,” Jeremy Siegel explained why stocks deliver better returns and less risk in the long term. As we will see, it doesn’t take many years for stocks to gain this advantage over bonds and U.S. Treasury bills.

He began by arguing that modern financial theory can help investors set out their portfolio allocations, once risk, expected return and correlations between asset classes are laid out. However, criteria such as risk are not permanently anchored, and vary according to economic circumstances.

As a result, bonds pose greater risks than stocks in the long run because of the uncertainty of inflation (something he explained in more detail in a previous chapter). Siegel wrote, “In this chapter investors will see that uncertain inflation will make their portfolio allocations depend crucially on their planning horizon.”

To help his readers visualize the dynamic shifts in returns over time for the three asset classes, Siegel created the following chart. It shows stocks in black and white bars, bonds in white and gray bars and Treasury bills in cross-hatching. The height of the bars shows the difference between the best and worst returns:


Several important insights are provided by this chart and the data behind it, including:

  • All three classes enjoy lower risks of loss over periods of up to 30 years.
  • The risk level of stocks declines more rapidly than it does for other asset classes.

Siegel observed:

“For 20-year holding periods, stock returns have never fallen below inflation, while returns for bonds and bills once fell as much as 3 percent per year below the inflation rate. During that inflationary episode, the real value of a portfolio of Treasury bonds, including all reinvested coupons, fell by nearly 50 percent. The worst 30-year return for stocks remained comfortably ahead of inflation by 2.6 percent per year, a return that is not far below the average performance of fixed-income assets.”

And, for emphasis, he added, “It is very significant that stocks, in contrast to bonds or bills, have never delivered to investors a negative real return over periods lasting 17 years or more.”

The author anticipated that some readers would ask if 20- to 30-year holding periods would be relevant. To that, he responded many investors think about the holding periods of individual stocks or other assets, but the appropriate holding period for portfolio allocation is the length of time an investor will hold specific asset classes in a portfolio.

Before the first edition of his book, published in 1994, the last 30-year period when bonds outperformed stocks ended in 1861, just before the Civil War. By the fifth edition, in 2014, another 30-year period of bond outperformance had just ended. That occurred between Jan. 1, 1982 and Dec. 31, 2011, and it reflected the peak of the inflationary run throughout the 1970s and early 1980s—in 1981, 10-year U.S. Treasury bonds topped out at 16%.

In the second half of the chapter, Siegel addressed the issue of risk and began by defining its standard measure: The standard deviation of average real annual returns. In the following chart from his book, he showed how risk falls as the holding period increases. For stocks, that reduction is dramatic:


Although stocks carry more risk than bonds in the early years, they carry less risk after 15 to 20 years. He wrote, “The standard deviation of average returns falls nearly twice as fast for stocks as for fixed-income assets as the holding period increases.”

Note the chart includes a measure for returns following a random walk, an approach in which future returns are considered fully independent of past returns. As Siegel noted, “This occurs since the actual risk of average stock returns declines far faster than predicted by the random walk hypothesis because of the mean reversion of equity returns.”

In addition, he pointed out the standard deviation of average returns for bonds and Treasury bills does not fall as fast as the random walk theory predicts. In this case, there is a mean aversion, rather than mean reversion.

Still, the author wanted investors to know there may still be a place for bonds, to diversify and reduce the overall risk of a portfolio. This case will be strongest when stock and bond returns are negatively correlated, i.e., move in opposite directions.

The correlation between asset classes is defined by a metric called the “correlation coefficient” and is based on a scale that ranges from -1 to +1. Investors searching for ways to diversify their portfolios will look for a lower number, generally between 0 and -1; the lower, the better. Note that the correlation between stocks and 10-year Treasuries varies across time periods.

Correlations change for several reasons, and one of the most prominent in the recent past was the switch from the gold standard to the fiat standard (or paper money standard) in 1971. Once that switch had occurred, inflation was more easily triggered since there were no longer limits on the amount of money that could be printed. And, during the 30 years from the mid-1960s to the mid-1990s, inflation was provoked by, among other things, governments printing money in attempts to boost their economies.

As a result, correlation was relatively high in that period, and government bonds contributed little diversity to portfolios. After 1998, however, that reversed for two main reasons. Siegel wrote that fears of deflation reawakened with the Asian monetary crisis of the late 1990s, and with the financial crisis of 2008, again stoking fears of a 1930s-type price collapse.

Siegel also wrote in 2014 or just before: “Nevertheless, it is unlikely that Treasury bonds will remain good long-term diversifiers, especially if the specter of inflation looms once again. If inflation does indeed increase, the premium now enjoyed by Treasury bonds as a hedge against deflation will again be lost, leading to further losses for bondholders.”

Finally, he looked at risk and return from the perspective of the “efficient frontier” theory, which aims to plot the best risk-return mixes on charts that show risk on the horizontal axis and returns on the vertical axis:


The author’s chart shows the least risky allocation is a function of the holding period:

“Investors with a 1-year horizon seeking to minimize their risk should hold almost their entire portfolio in bonds, and that is also true for those with the 2-year horizon. At a 5-year horizon, the allocation of stock rises to 25 percent in the minimum-risk portfolio, and it further increases to more than one-third when investors have a 10-year horizon. For 20-year horizons, the minimum-risk portfolio is over 50 percent in stock, and for a 30-year horizon it is 68 percent.”

Siegel wrapped up by observing that stocks are certainly riskier than fixed-income assets in the short run, but as the holding period increases, stocks become less risky. And anything beyond 15 to 20 years means stocks are safer than bonds or Treasuries.

(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)

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