Stocks Riskier than Bonds?2011 Nov 29
It is so common that stocks are riskier investments than bonds; nobody is even considering this question. Would I doubt it? Of course not, stocks are stocks and bonds are bonds. But I would like to look at it from quiet different angle.
I will not raise the question whether the stocks are riskier over short term. Stocks are definitely a riskier asset class under normal conditions over short-middle term period. But what if conditions aren’t very normal and the period is long term.
About the conditions I have already talked in my previous articles. The thing is that all the main currencies: USD, EUR and GBP are facing inflation pressure. US and UK are already on the way of increasing money supply (which I think is kind of smart decision) and Europe is expected to follow them sooner or later.
And if inflation is going to increase, it won’t be a short term jump on rise of commodities prices. It will be consistent medium range inflation (I would expect around 4%-5%) which may last for few decades. That inflation will have two main positive effects on economies: will wash down public debts, will be a help for banking system to get stronger. So we have real reasons to wait for it.
If it would become a reality, it would be really unpleasant scenario for bond holders. If our case would consider investing longer than 10 years, then we should ask, or even the safest bonds are safer than stocks?
Let’s try to analyze few examples. The yield of US 10 year government bonds now is 2%. The yield of German 10 year bonds is a bit higher, but in principle very similar.
In the graph you can see what could be the expected value of bonds in nominal and real terms, if inflation for the represented period would keep at 5% rate and annual yield of bonds would be 2%. Under such conditions after 10 years you would lose 25% in reality from investment in US government bonds. Of course, 5% inflation rate is hypothetical, but when everybody will forecast this rate, it will be too late to make adequate decisions.
If we believe that 5% inflation is possible (I think under current circumstances everything is possible), from investing in government bonds which is recognized as the safest investment, regarding risk of default, we would lose 25% of value only from inflation.
The second question: what is the probability that investments in stocks would bring 25% of loss after 10 years from now? I think that possibility is not so high, at least if you would use diversification effectively when investing in stocks. You could argument about Japan case, when stock market is still significantly at the loss after twenty years. I should agree that is possible, but in other hand Japan market was sky high and the drop had to be long and painful. Now markets are low and valuation multiples of stocks are low. That indicates the potential losses are not that high like they was at Japan case. Another thing is that Japan is a single market. And I would agree that after 10 years you could probably face a loss in some single particular market (even in that case loss could be lower than 25%). But if you would diversify stock investments properly, the probability of loss after 10 years is very low. That should mean, total world equities should have a drop in value, which is very hard to expect.
This assumption is made under condition that stocks are resistant to inflation. There might be rear occasions on the market when stocks can be hurt by inflation, but general stock market easily adjusts to inflation as well as real estate investments. If inflation increases, the prices of products or services increase the income of the companies. Higher income at the same profit margins means higher profits, which means higher value of the company. So companies resist the inflation.
Now we should put those two questions together. Which event has higher probability: average inflation of 5% over next 10 years or 25% loss in global stock market (in real terms). In my eyes, both assumptions are dramatically pessimistic, and have about equal probability to come reality.
If that would be true (any investment guru couldn’t predict that exactly), then stocks are better investment beyond any compare. The potential upside of long term bonds is limited to almost none. Stocks may offer impressive returns from current depressed basis.
What I want to say, risk is a relative matter. If we are investing for short term, fluctuations of anxious stock market should scary every investor for sure. But if we are ready to invest for longer than 10 year period, are such bonds really much safer investments than well diversified portfolio of stocks? I’m not sure, but even if investing in stocks is riskier, that risk isn’t sufficient to counterbalance possible returns.
Rokas Lukosius (author of investment book)
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