Are Stocks Less Risky Than Bonds?

Perhaps because of Monopoly, certainly because of WorldCom, and for many other reasons, the focus of this book has been the stock market, not the bond market (or real estate, commodities, and other worthy investments). Stocks are, of course, shares of ownership in a company, whereas bonds are loans to a company or government, and “everybody knows” that bonds are generally safer and less volatile than stocks, although the latter have a higher rate of return. In fact, as Jeremy Siegel reports in Stocks for the Long Run, the average annual rate of return for stocks between 1802 and 1997 was 8.4 percent; the rate on treasury bills over the same period was between 4 percent and 5 percent. (The rates that follow are before inflation. What’s needless to say, I hope, is that an 8 percent rate of return in a year of 15 percent inflation is much worse than a 4 percent return in a year of 3 percent inflation.)

 

Despite what “everybody knows,” Siegel argues in his book that, as with Monopoly’s hotels and railroads, stocks are actually less risky than bonds because, over the long run, they have performed so much better than bonds or treasury bills. In fact, the longer the run, the more likely this has been the case. (Comments like “everybody knows” or “they’re all doing this” or “everyone’s buying that” usually make me itch. My background in mathematical logic has made it difficult for me to interpret “all” as signifying something other than all.) “Everybody” does have a point, however. How can we believe Siegel’s claims, given that the standard deviation for stocks’ annual rate of return has been 17.5 percent?

 

If we assume a normal distribution and allow ourselves to get numerical for a couple of paragraphs, we can see how stomach-churning this volatility is. It means that about two-thirds of the time, the rate of return will be between -9.1 percent and 25.9 percent (that is, 8.4 percent plus or minus 17.5 percent), and about 95 percent of the time the rate will be between -26.6 percent and 43.4 percent (that is, 8.4 percent plus or minus two times 17.5 percent). Although the precision of these figures is absurd, one consequence of the last assertion is that the returns will be worse than -26.6 percent about 2.5 percent of the time (and better than 43.4 percent with the same frequency). So about once every forty years (1/40 is 2.5 percent), you will lose more than a quarter of the value of your stock investments and much more frequently than that do considerably worse than treasury bills.

 

These numbers certainly don’t seem to indicate that stocks are less risky than bonds over the long term. The statistical warrant for Siegel’s contention, however, is that over time, the returns even out and the deviations shrink. Specifically, the annualized standard deviation for rates of return over a number N of years is the standard deviation divided by the square root of N. The larger N is, the smaller is the standard deviation. (The cumulative standard deviation is, however, greater.) Thus over any given four-year period the annualized standard deviation for stock returns is 17.5%/2, or 8.75%. Likewise, since the square root of 30 is about 5.5, the annualized standard deviation of stock returns over any given thirty-year period is only 17.5%/5.5, or 3.2%. (Note that this annualized thirty-year standard deviation is the same as the annual standard deviation for the conservative stock mentioned in the example at the end of chapter 6.)

 

Despite the impressive historical evidence, there is no guarantee that stocks will continue to outperform bonds. If you look at the period from 1982 to 1997, the average annual rate of return for stocks was 16.7 percent with a standard deviation of 13.1 percent, while the returns for bonds were between 8 percent and 9 percent. But from 1966 to 1981, the average annual rate of return for stocks was 6.6 percent with a standard deviation of 19.5 percent, while the returns for bonds were about 7 percent.

 

So is it really the case that, despite the debacles, deadbeats, and doomsday equities like WCOM and Enron, the less risky long-term investment is in stocks? Not surprisingly, there is a counterargument. Despite their volatility, stocks as a whole have proven less risky than bonds over the long run because their average rates of return have been considerably higher. Their rates of return have been higher because their prices have been relatively low. And their prices have been relatively low because they’ve been viewed as risky and people need some inducement to make risky investments.

 

But what happens if investors believe Siegel and others, and no longer view stocks as risky? Then their prices will rise because risk-averse investors will need less inducement to buy them; the “equity-risk premium,” the amount by which stock returns must exceed bond returns to attract investors, will decline. And the rates of return will fall because prices will be higher. And stocks will therefore be riskier because of their lower returns.

 

Viewed as less risky, stocks become risky; viewed as risky, they become less risky. This is yet another instance of the skittish, self-reflective, self-corrective dynamic of the market. Interestingly, Robert Shiller, a personal friend of Siegel, looks at the data and sees considerably lower stock returns for the next ten years.

 

Market practitioners as well as academics disagree. In early October 2002, I attended a debate between Larry Kudlow, a CNBC commentator and Wall Street fixture, and Bob Prechter, a technical analyst and Elliot wave proponent. The audience at the CUNY graduate center in New York seemed affluent and well-educated, and the speakers both seemed very sure of themselves and their predictions. Neither seemed at all affected by the other’s diametrically opposed expectations. Prechter anticipated very steep declines in the market, while Kudlow was quite bullish. Unlike Siegel and Shiller, they didn’t engage on any particulars and generally talked past each other.

 

What I find odd about such encounters is how typical they are of market discussions. People with impressive credentials regularly expatiate upon stocks and bonds and come to conclusions contrary to those of other people with equally impressive credentials. An article in the New York Times in November 2002 is another case in point. It described three plausible prognoses for the market—bad, so-so, and good—put forth by economic analysts Steven H. East, Charles Pradilla, and Abby Joseph Cohen, respectively. Such stark disagreement happens very rarely in physics or mathematics. (I’m not counting crackpots who sometimes receive a lot of publicity but aren’t taken seriously by anybody knowledgeable.)

 

The market’s future course may lie beyond what, in chapter 9, I term the “complexity horizon.” Nevertheless, aside from some real estate, I remain fully vested in stocks, which may or may not result in my remaining fully shirted.

A Stock-Newsletter Scam

The accounting scandals involving WorldCom, Enron, and others derived from the data being selected, spun, and filtered. A scam I first discussed in my book Innumeracy derives instead from the recipients of the data being selected, spun, and filtered. It goes like this. Someone claiming to be the publisher of a stock newsletter rents a mailbox in a fancy neighborhood, has expensive stationery made up, and sends out letters to potential subscribers boasting of his sophisticated stock-picking software, financial acumen, and Wall Street connections. He writes also of his amazing track record, but notes that the recipients of his letters needn’t take his word for it.

 

Assume you are one of these recipients and for the next six weeks you receive correct predictions about a certain common stock index. Would you subscribe to the newsletter? What if you received ten consecutive correct predictions?

 

Here’s the scam. The newsletter publisher sends out 64,000 letters to potential subscribers. (Using email would save postage, but might appear to be a “spam scam” and hence be less credible.) To 32,000 of the recipients, he predicts the index in question will rise the following week and to the other 32,000, he predicts it will decline. No matter what happens to the index the next week, he will have made a correct prediction to 32,000 people. To 16,000 of them he sends another letter predicting a rise in the index for the following week, and to the other 16,000 he predicts a decline. Again, no matter what happens to the index the next week, he will have made correct predictions for two consecutive weeks to 16,000 people. To 8,000 of them he sends a third letter predicting a rise for the third week and to the other 8,000 he predicts a decline.

 

Focusing at each stage on the people to whom he’s made only correct predictions and winnowing out the rest, he iterates this procedure a few more times until there are 1,000 people left to whom he’s made six straight correct “predictions.” To these he sends a different sort of follow-up letter, pointing out his successes and saying that they can continue to receive these oracular pronouncements if they pay the $1,000 subscription price to the newsletter. If they all pay, that’s a million dollars for someone who need know nothing about stock, indices, trends, or dividends. If this is done knowingly, it is illegal. But what if it’s done unknowingly by earnest, confident, and ignorant newsletter publishers? (Compare the faithhealer who takes credit for any accidental improvements.)

 

There is so much complexity in the market, there are so many different measures of success and ways to spin a story, that most people can manage to convince themselves that they’ve been, or are about to be, inordinately successful. If people are desperate enough, they’ll manage to find some seeming order in random happenings.

 

Similar to the newsletter scam, but with a slightly different twist, is a story related to me by an acquaintance who described his father’s business and its sad demise. He claimed that his father, years before, had run a large college-preparation service in a South American country whose identity I’ve forgotten. My friend’s father advertised that he knew how to drastically improve applicants’ chances of getting into the elite national university. Hinting at inside contacts and claiming knowledge of the various forms, deadlines, and procedures, he charged an exorbitant fee for his service, which he justified by offering a money-back guarantee to students who were not accepted.

 

One day, the secret of his business model came to light. All the material that prospective students had sent him over the years was found unopened in a trash dump. Upon investigation it turned out that he had simply been collecting the students’ money (or rather their parents’ money) and doing nothing for it. The trick was that his fees were so high and his marketing so focused that only the children of affluent parents subscribed to his service, and almost all of them were admitted to the university anyway. He refunded the fees of those few who were not admitted. He was also sent to prison for his efforts.

 

Are stock brokers in the same business as my acquaintance’s father? Are stock analysts in the same business as the newsletter publisher? Not exactly, but there is scant evidence that they possess any unusual predictive powers. That’s why I thought news stories in November 2002 recounting New York Attorney General Eliot Spitzer’s criticism of Institutional Investor magazine’s analyst awards were a tad superfluous. Spitzer noted that the stock-picking performances of most of the winning analysts were, in fact, quite mediocre. Maybe Donald Trump will hold a press conference pointing out that the country’s top gamblers don’t do particularly well at roulette.