There is an old joke that some statisticians tell, that “a person with their head in an oven and their feet in the freezer is comfortable — on average.” Statisticians are not known for their sense of humor (clearly), but the joke is an effective warning about some of the shortcomings of relying on averages.
Statistically, a simple average camouflages extremes within its sample data. And, while the statistician’s joke is somewhat extreme, it is no less extreme than the actual returns in the long-run average annual returns for stocks and bonds that set many investors’ return expectations.
What’s an 'average' annual return anyway?
If quizzed, it is likely that many investors would estimate the average annualized returns for U.S. stocks and bonds to be about 10% and 5%, respectively. Those averages are composed of decades of returns and describe history perfectly. However, although they describe the average annualized returns, they are a far cry from the typical or "average" experience. In fact, in only two years from 1926 through 2020 did both the stock and bond market deliver returns within 2% (+/-) of their historical averages (see Figure 1).
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Figure 1: Annual stock and bond returns, 1926-2020
(Image credit: Source: Liberty Wealth Advisors, using data from Morningstar Direct)
In 2021, U.S. stocks gained 25.7%, while U.S. bonds lost 1.5%.* While it is fair to say that it was a great year for stocks, is it fair to say that it was a bad year for bonds because they didn’t return their 5.7%* average? Probably not. The only thing rarer than a year with “average” returns might be a year that investors appreciate their bond allocations amid a bull market for stocks.
For those of you thinking about abandoning bonds, here are some ideas that may help:
A bad day for stocks is often much worse than a bad year for bonds.
While investors prefer gains to losses, they also prefer small losses to big losses. While far from being predictive, Figure 1 demonstrates that negative returns in bonds have tended to be both infrequent and modest. In fact, the bond market’s worst annual return was a loss of 5.1% in 1994. However, the stocks of the S&P 500 index have posted daily losses that bad or worse 25 times since 1926.
Sometimes, the further the distance, the clearer the picture.
Often, it’s hard for investors to see the benefits that high-quality bonds can add to their portfolios, especially when the returns they are posting are modest — or even modestly negative. And today, concerns for higher interest rates due to higher-than-expected inflation are making it even more challenging for investors to ignore some pundits’ suggestions that holding bonds is a bad idea.
I was given a magnifying glass when I was young, and I started looking at everything through it. Eventually, I looked at the Sunday comics and realized that for all I saw, I wasn’t seeing everything. The cartoons were nothing but a variety of colored dots! Magazine photos, too. It made me wonder how much else I was missing because I wasn’t looking closely enough. Now, I realize that when I was close enough to see the dots, I missed the bigger picture – literally.
Similarly, the dots in Figure 1 paint a picture that’s easy to overlook when you’re too narrowly focused: The principal benefit of investment-grade bonds isn’t their frequency of positive returns but the infrequency of large, negative returns. And, yes, if the returns in Figure 1 were inflation-adjusted, the frequency of negative returns for both bonds and stocks would increase. However, that would not change what Figure 1 tells us: High-quality bonds in a portfolio can help moderate the volatility of stocks.
The bottom line: Keep your eye on the big picture.
A well-diversified portfolio can benefit from bonds: More likely than not, a bad year for bonds will be much better than a bad day for stocks. While that certainly won’t insure your portfolio against losses, it can certainly help moderate the losses when the markets turn intemperate.
Having a well-diversified portfolio that includes an allocation to high-quality bonds can help keep a bad day in the stock market from turning into a bad year for your portfolio.
* Stock performance as measured by the CRSP U.S. Total Market Index. Bond performance as measured by the Bloomberg U.S. Aggregate Float Adjusted Index. Bond average is a geometric mean return for the Ibbotson® SBBI® U.S. Intermediate-term (5-Year) Government Bonds (Total return).
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As a seasoned financial expert with a comprehensive understanding of investment strategies and statistical analysis, I can confidently delve into the nuances of the article you've shared. My expertise extends to the complexities of financial markets, investment vehicles, and the statistical principles that underpin these domains.
The article discusses the pitfalls of relying solely on average returns, drawing attention to the deceptive nature of averages, particularly in the context of stock and bond market performances. The author emphasizes the importance of understanding the broader picture and challenges the common perception of average annual returns for U.S. stocks and bonds.
The key concepts covered in the article are:
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Averages Can Mask Extremes: The introductory joke about statisticians highlights the tendency for simple averages to camouflage extremes within sample data. This sets the stage for the main argument that relying on average returns may not accurately reflect the typical investor experience.
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Historical Average Returns: The article mentions the commonly held beliefs about the average annualized returns for U.S. stocks and bonds, estimated at around 10% and 5%, respectively. However, it cautions that these averages, while accurate over the long term, may not align with the typical or "average" experience for investors.
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Market Volatility: The discussion of annual stock and bond returns from 1926 to 2020, illustrated in Figure 1, underscores the volatility of these markets. It points out that in only two years did both markets deliver returns within a narrow range of their historical averages.
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Yearly Performance Discrepancies: The article uses the example of 2021 to illustrate the disparity between stock and bond market performance. While U.S. stocks gained 25.7%, U.S. bonds lost 1.5%, challenging the notion that a year with below-average returns for bonds should be considered a bad year.
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Risk Mitigation through Bonds: The article argues for the importance of maintaining bond allocations in investment portfolios. It suggests that, despite modest or negative returns in bonds, they serve as a hedge against the potentially larger losses that can occur in the stock market.
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Inflation-Adjusted Returns: The mention of inflation-adjusted returns in Figure 1 reinforces the idea that high-quality bonds contribute to portfolio stability by mitigating the impact of market volatility, particularly during periods of inflation.
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Diversification and Portfolio Resilience: The bottom line emphasizes the value of a well-diversified portfolio that includes high-quality bonds. It suggests that even in a bad year for bonds, the overall impact on a diversified portfolio is likely to be less severe than a bad day for stocks.
In conclusion, the article underscores the significance of understanding the limitations of averages and advocates for a nuanced approach to investment, considering both historical trends and the unique dynamics of each market phase.
