THE BLOG
10/12/2012 08:56 am ET Updated Dec 12, 2012

The Ethical Investor : Wall Street Ripoff #7 - In the Long Run, Equities Outperform Bonds

We saw in the last post in this series that bonds may not be as safe from the very real risk of future inflation as we thought. Now, we would like to suggest that equities or common stocks don't always do better than bonds in the long run. What's a person to do? Bonds risky and unsafe, equities may go down in real value in long run, not up. It is one reason I think people should explore holding more real assets like commodities and real estate in their portfolios rather than all paper financial assets like stocks and bonds.

Wall Street brokers often pitch common stocks by saying that, yes, they can be more volatile in the short run, but over the long run they outperform bonds. The thought is that because equities have a higher expected return associated with them than bonds, they will always do better than bonds over a long horizon. But, equities have this higher expected return because they are riskier than bonds. And you cannot eliminate this higher risk just by holding the equities for a longer time period. In the long run, things trend toward their expected value, but probability and risk prevent them from ever getting there with certainty. The big mistake big sophisticated banks made in this latest financial crisis is that they thought they understood investment risk so well that they could leverage up and guarantee their expected returns with certainty. That is impossible in a volatile world of unexpected events. One thing we can be certain of, the future will always differ from the past and thus be uncertain.

This fallacy that equities outperform bonds in the long run, but are subject to greater volatility in the short run, leads advisers to recommending that young people hold a greater percentage of their wealth in stocks than someone closer to retirement. We have seen that this is bad advice on two fronts. One, seniors are being pushed into holding long bonds that they believe are low risk, but in fact have the potential to be immediately decimated in price and purchasing power if inflation reignites like I think it will. Two, it is used by unscrupulous brokers to convince young people that their money is safe in the stock market. That, over time, their stocks will grow even faster than holding bonds which people presume are fairly safe.

It always amazes me that risk-averse small investors who wouldn't think of betting $1,000 in Vegas don't mind turning their entire life savings over to a broker they hardly know to invest in the stocks of a bunch of companies they know nothing about. It would be like a stranger coming up to you with a proposition to invest your savings in a hundred old antique desks. Certainly, your lack of knowledge of him, his antique desks or how to value them would prevent you from investing with him, but no such logic prevents investors from investing in the stock market. Heck, most small investors couldn't figure out how to value a company or its stock even if they were somehow magically given the company's exact earnings and dividend stream going forward with certainty.

As with all fallacies, there is a little truth in the belief that stocks always outperform bonds. Academics identified an unusually large equity premium of about 6% per year in the period 1900 to 1985 and called it the "equity premium puzzle" because it shouldn't have been as large according to their own finance theories. In other words, it appeared that holding US stocks yielded an additional 6% return per year over holding short risk-free US Treasury securities. Who wouldn't jump at a chance to earn an additional 6% a year over the long haul just because the return in the short run might me a bit more volatile?

Well, like many of these opportunities that academics uncover in the real world, this unusually large equity premium disappeared from 1985 to the present. You can argue that it disappeared because of the market crash, but that is my whole point. The reason that equities appear to outperform bonds in the short run is that we haven't properly accounted for worst case scenarios, or long tails, that seem to happen when we least expect them. I would argue that the large equity premium that was observed for the US stock market in the last century resulted from the fact that the US turned out to be the big global winner, not only in wars, but global economic competition. Can you be certain that the US will be the big winner economically in the 21st century? Low wage countries with huge populations like China and India want their day in the sun and demographics are working against the US as our population continues to age, retire from productive working and need more medical and nursing care. The 20th Century was also a good century for capitalism and capitalists. You would expect stock markets to do well if capitalism did well.

I am not suggesting that a well constructed portfolio not include equities in it. While I wouldn't hold any long bonds right now because of inflation risk, I would hold some percentage of my assets in non-bank and non-high tech equities. You see, I think equities are cheap now because I think in real terms they are not near an all-time high as pundits suggest, but rather near a low. But, don't kid yourself. They are not guaranteed to go up faster than inflation in the long run and they are not guaranteed to do better than holding other assets. I am advising my investing clients to hold many more real assets like real estate financed partly with long fixed rate mortgage debt as I believe when inflation reignites real assets will outperform most equities and will crush real bond yields which will turn hugely negative. And in a world of expected higher inflation, it is always good to have some strategic long maturity fixed rate debt on your books even if you don't need the money.

Readers to my column have suggested TIPS as a way to go to survive the coming inflationary deluge of new money being printed by the Fed. TIPS are inflation adjusted securities issued by the US Treasury that return a stated real return determined by the market and then automatically adjust each year to compensate the investor for whatever the inflation rate actually was over the period. I recommended TIPS in my 2008 book, Contagion, but have backed off a bit lately as I worry whether or not the government's measurement of CPI will fully capture true inflation in the future. Certainly, to date, CPI has done a poor job recognizing and accounting for inflation in the costs of housing, college tuition and healthcare which happen to be some of the biggest consumption items on an average family's plate. TIPS also deal only with historical inflation so do not move in price quickly enough to reflect greater expected inflation in the future.

Investors have been lulled to sleep by the lullaby song of stockbrokers and bankers who croon that bonds are safe and that equities always outperform bonds in the long run. Wake up before another nightmare market crash shakes you violently from your peaceful slumber.

20 Ways Wall Street is Ripping Off Small Investors

  1. Providing nominal returns, not real returns.
  2. Encouraging too much diversification, if that's possible.
  3. Hiding fees and expenses.
  4. Turning you into a passive investor.
  5. Convincing you that money markets are the same as cash.
  6. Telling you that bonds are safer than equities.
  7. Explaining that in the long run equities outperform bonds.
  8. Simply by lying about their products.
  9. Convincing you that their bank is a large, stable, safe operation to deal with.
  10. Recommending products that have enormous sales commissions attached to them.
  11. Cheating you on bid/ask spreads.
  12. Selling you what they don't want.
  13. Measuring your success in dollars.
  14. Lending your securities to others.
  15. Ripping your eyes out if you ever try to close your account.
  16. Grabbing any slight positive real return for themselves.
  17. Sticking toxic waste to small investors.
  18. Pretending they can pick stocks.
  19. Acting like they are your best friend and they have your best interests at heart.
  20. Knowing next to nothing about the value of holding real assets like gold and real estate.

John R. Talbott is a bestselling author and financial consultant to families whose books predicted the housing crash, the banking crisis and the global economic collapse. You can read more about his books, the accuracy of his predictions and his financial consulting activities at www.stopthelying.com.

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