Long term, stocks are far superior to bonds

Dave Sheaff Gilreath:©Sheaff Brock Investment Advisors

If a substantial amount of your portfolio is in bonds, you may have been re-thinking this since the Federal Reserve board cut a key interest rate in September.

You often hear that the Fed cuts or raises interest “rates,” but this isn’t really the case. The Fed controls the Federal Funds rate—the one that banks pay on the short-term loans from the Fed that they need to function. That rate affects pretty much all others in the U.S.

The September cut signals the beginning of a cutting cycle that’s likely to bring down most interest rates in the U.S. economy. As the cutting cycle takes hold and works its way into the economy in the coming months, bonds will be paying investors lower rates.

If you’re thinking about reducing your portfolio allocation to bonds in response, that’s a good idea. But you probably shouldn’t have had much investment in bonds, if any, in the first place.

Now is a good time—just about any time is—to convert these bonds to other assets, mainly stocks.

From all the attention that financial media pay to bonds, you’d think they’re much better investments than they actually are. But much of this coverage is for professional investors, including those managing pensions that maintain heavy bond investments to pay out benefits. Also, bonds may get a lot of attention because their movements are generally viewed as being reflective of changes in the economy.

But no matter how you slice it, bonds just don’t pay investors much, compared with stocks.

Bonds in your portfolio are like a fifth wheel on your car: They suck up precious energy, in the form of investment capital, without advancing the vehicle. Actually, holding bonds instead of stocks creates a drag on profits, much as a fifth wheel adds unnecessary friction.

Many individuals persist in larding their portfolios with bonds because they believe that bonds carry little or no risk. But this misconception ranks among the most pervasive myths of modern times.

As with stocks, the value of bonds fluctuates, so you may be disappointed with what you get if you sell your bonds on the secondary market. You can avoid this risk by holding bonds until maturity, but then you run the risk that inflation may significantly reduce the buying power of the money you’re left with.

Sure, stocks fluctuate in value, as volatility is a natural part of the market. When you buy and sell are critical determinants of profit. Yet, contrary to what many investors habitually do, the idea is to hold onto stocks long-term.

Conventional financial-planning principles have long held that older people should have a substantial allocation to bonds approaching and during retirement because stock market volatility may force retirees to sell low when they need money to pay living expenses.

This thinking has always been misguided for many, especially well-heeled retirees like former physicians, because they have enough wealth to comfortably keep most of their money in stocks, letting it grow without touching it.

The superiority of stocks over bonds is supported by reams of reams of studies based on historical market data. Yet many investors, perhaps unaware of this information, persist in maintaining bond-heavy portfolios.

And to the extent they own bonds, they miss out on superior returns from stocks over the long run.

There are many compelling reasons to hold stocks instead of bonds—even to the extent of not owning a single bond.Here are just a few of the many reasons to avoid bonds in favor of stocks:

• Bonds just don’t pay investors much, while stocks do over the long run. The recent sustained period of high interest rates, which will soon end now that the Federal Reserve board has begun cutting, resulted in investment-grade corporate bond yields of about 5% annually at the peak about a year ago—now closer to 4%. But the long-term average return of the stock market is about 10% annually.
  About 60% of the time, the market goes up in a given year. But the chances of losing money in bonds over any 10-year period are seven times greater than in stocks.
• In the last few decades, amid consistently unsettling news and a near-depression in 2008, stock market returns have been historically quite strong on average.
  After finishing 1981 (my first year in the business) at 875, the Dow grew to an astonishing 28,000 by 2019. Then came a several-year period marked by market pullbacks, the Black Swan event of the pandemic, a recession, and a bear market. But the market has consistently come back, with the Dow closing Oct. 8, 2024, at about 42,000.
  In stark contrast to meteoric stock market growth in recent decades, the iShares Core U.S. Aggregate Bond ETF (AGG), a commonly used benchmark for bond market performance, has actually lost 2.6% in price since its inception in 2003, although it had a slightly positive total return (which includes yield), according to data from Schwab.
  This demonstrates how the ravages of inflation and investors’ reactions to it can savage bond performance.
  A comprehensive study of investment returns since 1928 by New York University’s prestigious Stern School of Business shows that the performance disparity between stocks and bonds indicated by AGG’s record is historically typical.
  The best year for bonds in the past two decades was 2019, when the Aggregate Bond Index earned a total return of 8.7%. While this was an especially good year for bonds, it was far better for stocks. The S&P 500 returned more than 31% (including dividends).
• You can get a nice, reliable, bond-like return from stocks that pay reliable dividends. With bonds, you’re guaranteed to get the same, dreary yield every year; you never get a raise.
  But when corporate boards increase dividends, stockholders get a slight increase in investment income. In most cases, stocks of companies that reliably increase dividends every year are good ones to own for other reasons, as they’re solid, mature companies that aren’t going away.
  Stocks that have increased dividends every year for decades have a special status. They’re known as dividend aristocrats or dividend achievers, monikers used in funds owning shares of these performers.
  The gradually increasing dividends of such stocks have enabled shareholders to double their dividend income every 11 years. And if shares appreciate, which is generally likely on average over the long run, investors can ultimately sell them for a profit. With bonds, you just get the money you invested, plus the annual yield; that’s it.
• Some alternative investments (those that aren’t bonds or regular stocks) can provide far more income than bonds.
  Among these are preferred stocks, many of which have recently been paying 6% or more but may go down to about 5% with the coming Fed interest rates cuts. Another is real estate investment trusts (REITs), landlord companies that own or lease out various types of real estate and pass most of this income along to investors in the form of dividends.
  Many REITs have been paying 6% or more during the period of high interest rates in recent years. If this goes down to 4 or 5%, it will still be a lot better than the roughly 3% level to which corporate bond yields will likely descend (lower for Treasuries).
  Moreover, these alternative investments may rise in value, enabling profits upon sale.
• You may live longer than you think. If you have a lot of your portfolio in bonds, this may jeopardize your retirement resources.
  Traditional financial planning notions have long held that people should increase their portfolio allocations to bonds and decrease their holdings in stocks as they age. But ironically, this actually increases the risk that many couples could outlive their money or whittle down their legacies.
  Along with underestimations of bond risks, misunderstandings about longevity make this scenario more likely. Many people aren’t aware of up-to-date longevity statistics for those who have made it to age 65, showing that they have a good statistical chance of living well into their 80s or possibly their mid-90s—more than decade longer than they expect.
  These misguided expectations are the unfortunate result of reliance on a rather Darwinian statistic known as “longevity at birth,” which includes the longevities of people who die prematurely. It makes no sense to use this stat to estimate the remaining years of people who have made it to retirement age, as they’re likely to live much longer than indicated by life expectancy at birth.
  The unfortunate result is that retirees who are way over-invested in bonds end up missing out on the superior returns of the stock market during unexpected years of life.

Dave Sheaff Gilreath, CFP,® is a founder and chief investment officer of Sheaff Brock Investment Advisors, a firm serving individual investors, and Innovative Portfolios,® an institutional money management firm. Based in Indianapolis, the firms were managing assets of about $1.4 billion as of June 30, 2024.

Investments mentioned in this article may be held by those affiliates,Innovative Portfolios’ ETFs, or related persons.