How much of your 401(k) should you really have in stocks versus bonds?

MW How much of your 401(k) should you really have in stocks versus bonds?

By Brett Arends

History shows that stocks are far from guaranteed to beat bonds over the long term

When it comes to investing your money for your retirement, there's a very clear, well-established conventional wisdom among financial advisers.

In a nutshell: For anyone looking at the long term, you should hold as much of your 401(k), your IRA and other accounts in the stock market as you can bear. That's because stocks always produce by far the best returns, assuming you hold them for long enough. The only reason to hold bonds is to minimize the "risk," defined as volatility, along the way.

This conventional wisdom has become so enshrined that you are effectively required to pay lip service to it to get various financial credentials so you can put letters after your name. Dissent is heresy.

There's a lot to justify this argument, not least recent history. Since State Street launched its highly popular S&P 500 SPX index fund, the SPDR S&P 500 ETF Trust SPY, 21 years ago, it has outperformed a typical bond fund by a factor of seven. During that time, SPY has turned $10,000 into just over $200,000. The Vanguard Total Bond Market Index Fund ETF BND over the same period: Just $36,000. In the last five years, the total return on the SPY is over 90%; the bond fund is actually down by a couple of percent.

But is this argument correct?

Maybe not. This conventional wisdom is a castle built on sand, warned Edward McQuarrie, professor emeritus of the business school at Santa Clara University, in the CFA Institute's Financial Analysts Journal. It's built on flawed historical data that have since been debunked.

Instead, he wrote, history shows that stocks are far from guaranteed to beat bonds over the long term. In fact, they are not even guaranteed to beat inflation.

"Sometimes stocks win, and sometimes they lose," according to McQuarrie. "Sometimes stocks fall behind bonds only briefly, at the depths of a bear market, while at other times the disadvantage is sustained well past that bottom." Long-term historical data, much of it uncovered quite recently, "does not show a stock advantage that waxes and wanes, but a stock advantage that repeatedly reverses into a deficit."

Fresh historical research, for example, now reveals that U.S. stocks underperformed bonds over the course of the entire 19th century. Previous research flattered the performance of stocks, and underestimated the returns from bonds. And the story is similar when we look at the international record, McQuarrie added. There have been many long periods, even in developed markets untroubled by conquest or revolution, when stocks did worse than bonds over long periods of time.

Nor is it accurate to say that stocks have always, or even usually, generated "real" or post-inflation returns averaging 6% or 7%, he said. "Over multi-decade holding periods, there have been repeated instances where the real total return on stocks was 2% or less."

Ouch.

The argument that "stocks always win" became cemented in the finance industry about a quarter-century ago. It was heavily influenced by the immediate post-World War II decades in the U.S.: From the 1940s to the early 1980s, U.S. stocks absolutely crushed bonds by an order of magnitude. But historical data now show that this period was exceptional, not the norm. Going back centuries in the U.S., or looking at data from countries overseas, shows many other cases when stocks did no better than bonds, or even worse.

This isn't all in the far-distant past, either. The outperformance of U.S. stocks lately has all been since 2009, and much of it since March 2020. From the launch of the SPY in 1993 through early 2009, bonds did better.

Much of McQuarrie's argument rests on fresh financial data going back as far as the 1790s - data that wasn't available when the popular "stocks-for-the-long-run" argument was first being popularized a quarter-century ago.

It shows how much of an anomaly the post-World War II period in America was - that stretch from the 1940s to the early 1980s when stocks crushed bonds. It was that period which cemented the idea that over the long term you wanted only stocks, not bonds.

"The new 19th-century data from the U.S. are not exceptional," he wrote. "Worldwide, there have been numerous instances where stocks underperformed bonds over multi-decade intervals. There is no law that guarantees an equity premium will be received if an investor buys and holds for decades. Once the historical lens is widened to include the 19th century in the U.S. or swung out to include markets outside the U.S., it is straightforward to find instances of bonds for the long run."

The conventional cult of stocks has always had a logical flaw. Stocks outperformed because they were "risky," went the argument. But if you held them for a decade or more, they actually weren't risky, it added. But if they weren't risky, why would they outperform?

As McQuarrie put it: "If stocks are risky, investors will demand a premium to invest. But if stocks cease to be risky once held for a long enough period - if stocks are certain to have strong returns after 20 years and certain to outperform bonds - then investors have no reason to expect a premium over these longer periods, given that no shortfall risk had to be assumed."

A premium for stocks only makes sense if there is a very real risk of long-term underperformance. History shows that there is.

It's a timely warning, especially at a time when the U.S. stock market is trading at extremely high valuations and sentiment is somewhere between complacent and euphoric.

This isn't an argument against stocks completely. But it's an argument against going overboard, and assuming stocks can't fail. They can and have.

McQuarrie ended up effectively endorsing the argument raised more than 20 years ago by the late and legendary financial analyst Peter Bernstein: That a portfolio of 60% stocks and 40% bonds makes sense - not just because stocks are volatile, but because stocks might disappoint.

-Brett Arends

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April 27, 2024 08:00 ET (12:00 GMT)

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