Bonds For The Long Run

Wall Street is quick to push the mantra that one should invest in stocks for the long run. But the question of the reliability of the equity risk premium, and just how long the long run is anyway, remain important questions for investors seeking to achieve their financial objectives.

So, I want to challenge the “stocks for the long run” thesis, and in fact demonstrate that stocks have provided all of their return in a limited number of bull markets. They spend most of their time either going down, or recovering from past losses, with extended periods where the only return for investors was their dividend. The case will be made for why bonds, continuously compounding one’s wealth, offer a competitive alternative for the long run.

Revisiting the Historical Case for Bonds

In 2009, Rob Arnott of Research Affiliates wrote a piece analyzing the historical record of bonds v. stocks, and the frailty of the equity risk premium. Today, emerging from a period of excess in the 2009-2021 period, this piece is an important reminder of the role of bonds in portfolio construction, and the historical record that favors bonds over stocks (emphasis added):

“Most observers…would be shocked to learn that the 40-year excess return for stocks, relative to holding and rolling ordinary 20-year Treasury bonds, is not even zero. Zero “risk premium”? For 40 years? Who would have thought this possible?…It’s hard to imagine that bonds could ever have outpaced stocks for 40 years, but there is precedent…

• From 1803 to 1857, stocks floundered, giving the equity investor one-third of the wealth of the bond holder; by 1871, that shortfall was finally recovered. Oh, by the way, there was a bit of a war—or three—in between. Forget relative wealth if you owned Confederate States of America stocks or bonds. Most observers would be shocked to learn that there was ever a 68-year span with no excess return for stocks over bonds.
• Stocks continued their bumpy ride, delivering impressive returns for investors, over and above the returns available in bonds, from 1857 until 1929. This 72-year span was long enough to lull new generations of investors into wondering “why bother with bonds?” Which brings us to 1929.
• The crash of 1929–32 reminded us, once again, that stocks can hurt us, especially if our starting point involves dividend yields of less than 3 percent and P/E ratios north of 20x. It took 20 years for the stock market investor to loft past the bond investor again, and to achieve new relative-wealth peaks.
• Then again, between 1932 and 2000, we experienced another 68-year span in which stocks beat bonds reasonably relentlessly, and we were again persuaded that, for the long-term investor, stocks are the preferred low-risk investment. Indeed, stocks were seen as so very low risk that we tolerated a 1 percent yield on stocks, at a time when bond yields were 6 percent and even TIPS yields were north of 4 percent.
• From the peak in 2000 to year-end 2008, the equity investor lost nearly three-fourths of his or her wealth, relative to the investor in long Treasuries…

Out of the past 207 years, stocks have spent 173 years—more than 80 percent of the time—either faltering from old highs or clawing back to recover past losses. And that only includes the lengthy spans in which markets needed 15 years or more to reach a new high.”

The evidence presented here demonstrates that over long periods of time, bonds have beaten stocks. But what is most interesting is looking at the components of the equity investors return. Some make the argument that dividends do not matter; the data disagrees, in fact dividends are THE most important factor in equity investing, as I will demonstrate from the data.

The Importance of Dividends to Equity Returns

“In real, inflation-adjusted terms, the 1965 peak for the S&P 500 was not exceeded until 1993, a span of 28 years. That’s 28 years in which—in real terms—we earned only our dividend yield … or less. This is sobering history for the legions who believe that, for stocks, dividends don’t really matter.” -Rob Arnott, Bonds: Why Bother?

Tweedy Browne & Co. has assembled a review of some of the studies proving the efficacy of dividend investing in their excellent paper ” The High Dividend Yield Return Advantage: An Examination of Empirical Data Associating Investment in High Dividend Yield Securities with Attractive Returns Over Long Measurement Periods.” Looking closely at some of the studies they explore, will demonstrate clearly the importance of dividends in equity returns.

In their text, “Triumph of the Optimists: 101 Years of Global Investment Returns,” authors Dimson, Marsh, and Staunton (2002) examined the composition of asset returns in both the US and U.K. market from 1900-2000. Their research found that long-term returns were driven by reinvested dividends. In fact, the return from reinvested dividends was 85 times that of a portfolio consisting of capital appreciation alone. The chart below demonstrates their findings.

“Figure 11-2 shows the equivalent UK returns both with and without dividend reinvestment. With dividends reinvested (the green line), an investment of £1 made at start-1900 in the UK stock market would have grown to £16,160 by the end of 2000. By coincidence, this is very close to the terminal wealth of $16,797 from a $1 investment in the US market. Since UK inflation was higher than US inflation, the United Kingdom had an annualized real return of 5.8 percent compared with 6.7 percent in the United States. If dividends had been spent rather than reinvested, the UK investment of £1 would have grown to just £149 (the red line), a nominal return of 5.1 percent. Over the same period, UK consumer prices rose 55-fold, so this corresponds to a real capital gain of 1 percent per year, compared with 2 percent real in the United States. The longer the investment horizon, the more important is dividend income. For the seriously long-term investor, the value of a portfolio corresponds closely to the present value of dividends. The present value of the (eventual) capital appreciation dwindles greatly in significance. The analysis above shows why, throughout this book, we have stressed the importance of dividends in computing total returns.” (Pg 151)

Additional research by Robert Arnott of Research Affiliates further proves the importance of dividends to long term investment returns. In a 2003 editorial in the Financial Analysts Journal, entitled Dividends and the Three Dwarfs, Arnott explored the returns of equity securities for 200 years, ending in 2002. He found that dividends were the most important component of return. Of the total annualized return for the period of 7.9%, 5.0% of that was from dividends, 1.4% from inflation, 0.6% from rising valuation levels, and 0.8% from real growth in dividends. He states:

“The importance of dividends for providing wealth to investors is self-evident. Dividends not only dwarf inflation, growth, and changing valuation levels individually, but they also dwarf the combined importance of inflation, growth, and changing valuation levels. This result is wildly at odds with conventional wisdom, which suggests that, while the return from bonds is wholly dependent on income, stocks provide growth first and income second. It is startling to realize that dividend growth has averaged less than 1 percent above inflation during the past 200-year period. And it is shocking that real per-share dividend and earnings growth on the S&P 500 Index since 1965 has been zero…” He ends “Dividends, unequivocally, matter.”

In a further global study of equity returns, entitled The Importance of Dividend Yields in Country Selection, in the Journal of Portfolio Management, A. Michael Keppler, studied the relationship between a firm’s dividend yield and their overall return. He found that an investment in the highest-yielding quartile produced the best investment return overall.

This is further demonstrated in Triumph of the Optimists: 101 Years of Global Investment Returns. In the 10th Chapter, the authors show the cumulative returns from 1926 to 2000 of U.S. stocks that rank each year in the highest or lowest yielding 30% of companies. They found that higher yielding stocks outperformed their low yielding counterparts, 12.2% to 10.4% respectively. Demonstrating again the importance of dividends.

Often-cited Wharton School Professor, Jeremy Siegel wrote a book entitled The Future for Investors. In this text. he ranks the components of the S&P 500 by dividend yield, for the time period 1957-2002. He found that the highest yielding stocks beat their lowest-yielding counterparts and the S&P 500 Index (SP500).

An Exploration of the Historical Record of Stock Returns 1871-2021

Stock market investors took the risk—riding out every bubble, every crash, every spectacular bankruptcy and bear market, over a 30-year stretch. How much were they compensated for the blood, sweat, and tears spilled with all this volatility? A measly 53 basis points per annum! Indeed, those that have incurred the ups and downs over the past decade have lost money compared to what they could have earned from long-term government bonds. They’ve paid for the privilege of incurring stomach-churning risk. Not only did Treasury bond investors sleep better, they ate better too!” – Rob Arnott, Research Affiliates

I looked at stock and bond returns from 1871-2021, 150 years of data. During this period the S&P Index provided investors with a compound annual growth rate (CAGR) of 2.60% adjusted for inflation, but without dividends. When we include dividends, this rises to 7.14%, so dividends, and not capital appreciation, accounted for nearly 64% of the total return from equity securities. What was also important was the time period during which you were an investor. If you invested for the 20-year period 1987-2007, your CAGR was 8.18%.

If, however, you invested from the period 1929-1949 your returns were 2.09% and negative without dividends. Looking at time periods of market history and the variation in returns demonstrates just what an outlier the last 12 years of QE fueled returns has been. If history is any guide, we should expect the return to the mean to be just as severe in reverse.

This chart shows the importance of timing, and valuation. Looking over 150 years you see that ALL of the gains occurred in five bull market periods, and even during these bullish periods, the market spent a good amount of time clawing back the gains from the previous cycle. When, you buy stocks, and at what price matters.

From 2009-2021 the stock market compounded at 13.54%! This is nearly double the CAGR from the 150-year period 1871-2021. Over the long run we should expect returns to cluster around the mean. Thus, after a period of outsized returns, mean reversion is to be expected. This is accomplished with a period of below average returns for equity securities. This may mean years with negative returns to bring the long run average return back in line with the mean.

The research presented here is only a sample of the many research studies that prove that dividends unequivocally matter over long time periods for stock investors. The cumulative data on stock returns, proves their unreliability during long periods of time, and further bolsters the case for bonds for the long run. To the extent that an investor is going to include stocks, the research is clear that dividend stocks are superior to the high-growth glamor stocks that have monopolized investors’ minds over the last decade.

Conclusion

This is a great exposition of the history of asset returns, I share it to set the stage for what I believe will be yet another extended period of outperformance for bonds. This period also makes dividends from stocks all the more important. As we saw from the historical data, the market has forced investors to suffer through multiple, extended periods where without dividends, investment returns were zero, or negative.

The historical record clearly shows that, while stocks can outperform for short periods, they are highly time dependent. The real reason to invest in stocks, based on the data, is the dividend. However, the dividend is not guaranteed, especially during periods of economic distress. U.S. Treasury Bonds, however, with a set maturity date and yield, demonstrate they are a compelling investment vehicle to compound wealth for the long run.