With a Little Bit of Time…

Stocks are riskier than bonds, right?

We're not trying to trick you. It's true. Everyone knows it. On a daily and even yearly basis, stocks are more volitile than bonds. Yep, it's a fact.

The problem is that it's a useless fact for most people. Relatively few invest for just a day or year. The vast majority of equity investors have a much longer time horizon.

We were pondering this conundrum the other day when a thought popped into our heads: what if we looked at stocks versus bonds over longer periods than just a year? The results were surprising.

Looking at 3 year annualized periods—that is, three year trailing returns—the results are much different. Looking back all the way to 1926, we find that bonds are a much riskier bet for your money than stocks.

Amazing? Not at all. First, we must take inflation into account. Most forget that real bond yields each year can in fact be negative. Inflation alone can spoil things. Second, because of differences in taxes it's a lot more costly to own bonds. Coupon payments on bonds are taxed as ordinary income (around 40% after federal and state dignitaries take their share). Capital gains taxes on stocks are far less.

For three year trailing periods, on an after-tax, inflation adjusted basis:

• 10-Year Treasury yields average a 1.4%
• S&P 500 Returns average 6.2%

But that's not all. When measured in this way, bonds actually have negative returns more often than stocks. And these are just for three year periods. If your time horizon is 15 years or more (as it is for most investors), stocks outperform bonds a whopping 98% of the time.

Stocks are riskier than bonds? No way. Bonds are riskier than stocks with just a little bit of time.

-------------------------------------------------------------------------
Long term capital gains tax set at a constant rate of 20%, tax on bonds set at a constant rate of 40%. Source: Global Financial Data; As of 12/31/2006.