Do shares outperform bonds? That depends on whether you are a good or bad investor

While it is true that equities outperform bonds in aggregate, the unequal performance of shares means not all equity portfolios will.

It’s a well-established maxim in investing that over the long term, equities outperform bonds. While stocks may be more volatile, the stability of bonds generally comes with lower performance over a longer time frame.

For example, as the latest Barclays Equity Gilt Study shows, while long dated gilts have slightly outperformed equities for the past two decades in the UK, since 1967 the average annual real returns on UK equities has been 5.6% versus 3.1% for bonds.

Similarly, the Barclays US Aggregate Bond Index, which is made up of US Treasuries, government agency bonds, mortgage-backed bonds and corporate bonds, saw an average annual gain of 7.87% between 1980 and 2017.

By contrast, the S&P 500 has seen average annual gain of 12.19%. When compared to just ultra-safe US government bonds, known as Treasuries, the outperformance of equities becomes even greater.

However, according to a recent study by Hendrik Bessembinder in the Journal of Financial Economics, the story is slightly more complicated. In a paper, titled ‘Do Stocks Outperform Treasury bills?’, Bessembinder focuses not on the average return of markets, but performance of individual stocks listed on the market.

Bessembinder compared the performance of equities listed on US markets between 1926 and 2016 to one month US Treasuries. What he found was that most stocks over that timeframe provided lower returns than bonds.  

Only 42.6% of stocks had lifetime buy-and-hold returns (including dividends) in excess of buy-and-hold returns for 1-month Treasury bill. The paper notes: “An answer to the question posed on the title of this paper is that most common stocks (slightly more than four out of every seven) do not outperform Treasury bills over their lives.”

But if most stocks don’t outperform bonds, why does most data show equities providing better returns compared to bonds? Because while the aggregate  performance of equities provides better returns than bonds, it is relatively few stocks within that market providing the outperformance.

The excess returns from the broad market, the study notes: “Is attributable to the positive skewness of the stock return distribution, i.e. to the relatively few stocks that generate large returns, not to the performance of typical stocks.”

To show the unequal distribution of returns among listed companies, Bessembinder looks at what he calls “aggregate wealth creation” in the US public stock markets. By this he means returns above what would have been received by capital invested in one month Treasury bills.

Since 1926, the 25,300 companies that appeared on US public markets have provided wealth creation of nearly $35 trillion as of December 2016. However, just five companies are responsible for 10% of that wealth creation (Exxon Mobile, Apple, Microsoft, General Electric, and International Business Machines).

It is important to note that dividends are another key reason why shares typically outperform bonds over long time periods. One of the key takeaways for beginner investors looking to improve their odds of stock market success, therefore, is to invest for the long term and reinvest both capital gains and income. Those who do will reap the rewards of compounding.

What does this mean for investors?

Simply put: while it is true that equities outperform bonds over the long term, not all equity portfolios will. Whether or not a portfolio full of shares provides higher returns than bonds depends on having the right equities in that portfolio. 

In response to this, investors may conclude that rather than attempting to make their own stock picks, they are better off investing in actively managed funds or trusts. The supposedly skilled stock pickers and their small army of researchers can, in theory, identify those stocks doing the heavy lifting in each market.

Of course identifying which managers will be able to pick such winners is no easy task. As is widely known, a large number of active managers that fail to produce market beating returns in their stock selection

That’s the famous point made by the Burton Malkiel, the economist and author known for his advocacy of passive investing. He noted that identifying an active manager that will pick the outperforming stocks “is like finding a needle in a haystack.” Instead: “I say buy the haystack," by which he means invest in an index tracker fund or ETF.

At Money Observer, we are advocates of mixing and matching between the two styles. But, in defence of active management, there are fund managers out there who over various market cycles have proved their worth by consistently gaining an edge over both the index and active fund manager rivals.

The trouble is that there are far more duds than gems, which makes finding a winner an uphill task. To help readers focus their sights on the superior options, Money Observer has created a shortlist of Rated Funds, which for 2018 features 199 funds. There is also our annual Consistent 30 series; highlighting funds that have reliably held their own over the past three years.

Either way, the research does underline the point that stock picking for most private investors is likely to lead to sub-optimal outcomes, considering the high number of dud stocks unlikely to produce much of a return.

Whether it is active or passive, investors have a better chance of seeing a good return through pooled investment vehicles.

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