DECEMBER NEWSLETTER

There is a dispute raging in the investment world about whether the old rules of investing need to be discarded and new rules applied. Simply put, the argument being advanced is that consumers are entering a new era of less borrowing and spending which will result in a lower average GDP than we’ve seen in the past several decades. As such stocks, which rely on earnings growth for appreciation, will be constrained in this "New Normal" level of lower economic growth. If true, slower growth would tend to favor bonds which pay a return even in periods of basically zero growth. Proponents of the New Normal thinking suggest that portfolio allocations should be revised with equity positions reduced to something around 50% of a portfolio with the balance largely in bonds. This is a vast departure from recent portfolio theory that argued for stock allocations approaching as much as 100% in long term portfolios. While I don’t entirely disagree with the New Normal way of thinking, looking at actual past returns suggests stock heavy allocations still perform best over long periods of time.

To get a fair analysis of the numbers, I think we need to look back well before the last two decades. The 80’s and 90’s were a fantastic time to be long stocks and as such tend to skew the numbers in favor of stock ownership, but even looking well before then, stocks still offered better returns than bonds. By analyzing 20 year periods starting back in the depression era, we can get a reasonable look at total returns through a variety of economic climates.

                                S&P 500*         Long Term Corp. Bonds*

1930 – 1950                  5.6%                          4.7%

1940 – 1960                 13.5%                         2.2%

1950 – 1970                 13.0%                         2.1%

1960 – 1980                   7.9%                         3.6%

* Annual, compound returns. Source: Dimensional Advisors

In almost all periods, stocks outperformed bonds by a substantial margin if held for the full 20 year period. Even if the stock purchases were exceptionally ill timed, bonds still didn’t offer a vastly superior return. As an example, a 20 year investment in the S&P 500 starting at the beginning of 1929, the year of the stock market crash, produced a 3.8% compounded annual total return versus 4.7% for long term corporate bonds over the same period*.

In fairness this picture changes dramatically when you look at much shorter time periods of 5 or 10 years. One need only look at the returns of the last 10 years to realize that it is very possible to experience time periods where bonds can in fact out perform stocks. What this all points to is that if we are entering a new normal economy, for portfolios with shorter time horizons it may pay to review your allocations. However, for longer time horizons, history suggests stocks still should outperform bonds provided you hold them for 20 years or more. New normal or not, stocks still should play a major role in your long term investment strategy.

Randy Gridley

December, 2009