by Rob Bennett
It is conventional investing wisdom that stocks are more risky than bonds. The purpose of this column is to question the conventional investing wisdom in light of Yale Economics Professor Robert Shiller’s startling finding that valuations affect long-term returns and that long-term stock returns are thus to a large extent predictable. Given Shiller’s findings, I do not think it makes sense anymore to believe that stocks are necessarily more risky than bonds.
There are two reasons why people have long thought that bonds are more risky than stocks. The first is that stock returns are more volatile. The second is that long-term stock returns are higher than long-term bond returns and common sense suggests that, given that stocks offer higher returns, there must be some reason why millions invest in bonds all the same. The presumed reason is that stocks are more risky; bond investors are giving up the equity risk premium in exchange for being able to invest with less risk.
Warren Buffett often points out the flaw in the first rational for believing that bonds are more risky than stocks: Volatility is not risk.
There is certainly some association between volatility and risk. An asset class that pays a specified return each year (Treasury Inflation-Protected Securities or IBonds) is properly viewed as a no-risk asset class because you know in advance what you are going to get; where there are no surprises, there is no risk. But it is a mistake to think that added volatility always translates into added risk. It is only downward price movements that dismay investors. Upward volatility is a plus. If there is one asset class that pays a guaranteed return of 3 percent real and another that is certain to pay a return of at least 3 percent real but which may pay a return of as high as 6 percent real, the latter asset class is the more volatile of the two asset classes but it is absurd to label the latter asset class the more risky of the two asset classes.
The Stock-Return Predictor reports that, at a time when stocks are priced at fair value (a P/E10 of 14), there is only a 20 percent chance that stock investors will see an annualized 10-year return of less than 3.34 percent real. Even that unlucky return is better than the return that can in most circumstances be obtained from risk-free asset classes. So the stock investor who buys stocks at fair value is in relatively good shape even if an unfortunate returns sequence happens to pop up. However, the odds are that this investor’s return will be much better. There is as much chance (20 percent) than the 10-year annualized return will be greater than 9.34 percent as there is that it will be less than 3.34 percent. The volatility of stocks purchased at fair value is much greater than the volatility of an IBond paying 2 percent real. But the risk is only in a trivial sense greater (there is a tiny chance that the return on stocks could be less than 2 percent).
Stocks are not more risky than bonds even in the trivial sense because bonds are more risky than asset classes providing guaranteed inflation-adjusted returns. Inflation can wipe out much of the investor’s expected return on bonds. So the tiny amount of risk attached to a stock investment initiated at a time of fair prices is less than the amount of risk attached to a bond investment.
Risk is not volatility. Risk is the possibility of loss of capital. Almost all of the volatility of stocks purchased at times of fair prices is upside volatility. Stocks purchased at times of fair prices are not more risky than bonds. Stocks puchased at times of low prices are often significantly less risky than bonds.
Can you believe it?
I acknowledge that this implication of Shiller’s research is hard to accept. That’s not because of any weakness in the logic chain. It’s because we have for so long accepted the idea that stock investors are behaving rationally that we have a hard time getting our heads around the implications of research showing that this is not so.
The second reason for believing that stocks are more risky than bonds is that it defies common sense to think otherwise. Stocks pay higher returns. It would make no sense for investors to buy bonds if bonds were more risky.
All that is so. The weakness in the conventional logic chain is the presumption that investors are rational. It is certainly the case that rational investors would not put their money in bonds if they paid lower returns and carried more risk. But Shiller’s key insight is that investors are often not rational. If investors were rational, there would be no overvaluation. If investors were rational, stocks would always be priced properly (and the market would be efficient and Buy-and-Hold would work).
Investors were not being rational when they invested heavily in stocks in January 2000, a time when stocks were selling at prices so high that the most likely annualized 10-year return was a negative number. If many investors could do that, many investors could elect bonds over stocks at a time when stocks carried less risk and offered higher returns. Assuming rationality on the part of investors will throw your analysis of the stock market off the right track every time.
Stocks can be more risky than bonds. Obviously there was huge risk when prices were so high that the likely long-term stock return was a negative number. But the risk of stock investing is a voluntary risk. It’s not that stock investors collectively take on more risk than the risk that is taken on by bond investors collectively. Stock investors who ignore valuations take on astronomical levels of risk. But stock investors who take valuations into consideration can easily keep their risk below the level taken on by bond investors.
It is not stock investing that is risky. It is valuation-uninformed stock investing strategies that are risky. The risks of stocks can be largely avoided by those willing to give consideration to the effect of valuations on long-term returns. It is much harder for investors to avoid the risks of bonds, since inflation is unpredictable and constitutes the biggest risk for bond investors. For the valuation-informed investor, bonds are more risky than stocks.