It's sure been a difficult time of late for stocks & shares. Over the last decade, the stock market has returned a feeble 0.6% vs. 3.9% for Gilts (and 1.6% for corporate bonds) and bonds have now matched or bettered stock returns over more than 30 years!
In light of this, there has been a lot of questioning recently about the relative attractiveness of shares versus bonds. Some suggest that investors should allocate entirely to bonds, not just because bonds are safer, but because they believe bonds will outperform shares over the long run. In other words, if bonds can deliver higher returns with less risk, what's the point of messing around with shares?
Citigroup wrote a piece in 2009 arguing that:
"The cult of equities was dead. Long live the cult of the bond".
Their theory: a half-century of bias of pension funds towards shares was reversing, and, given the lack lustre performance of shares, fund managers were instead turning to fixed-income investments for better returns.
We're mindful of Blaise Pascal's trap that "People almost invariably arrive at their beliefs not on the basis of proof but on the basis of what they find attractive" but, before jumping on the bond band-wagon, we feel that it's worth being cautious for three reasons:
- Fundamental analysis supports the idea that shares should outperform
- The long run (and really long run) evidence still clearly indicates (by miles!) the superiority of shares versus bonds.
- There's grounds for believing that our recent experience with bonds has been highly unusual (even if it has lasted 30 years!)
What's the difference between shares and bonds?
The essential difference between shares (equity) and bonds is that investing in shares is about buying partial ownership in a company, as opposed to bonds which involve making a loan to it. When an investor buys shares, the value will tend to reflect the earnings experience of the firm — good and bad. In contrast, bonds can never earn more than its face value (plus coupons). shares have (theoretically) an unlimited ability for appreciation but, at the same time, greater downside risk (because they are lower down the capital structure in the event of an bankruptcy). Their returns can be decomposed as:
i) Bond return = Current yield + Capital gain
ii) Stock return = Current yield + Earnings growth + Price Earning multiple change