Expected Returns

Measurement of returns is difficult over the past 25 years. It has been an abnormal period for both bonds and stocks.

Bonds with coupons that pay defined amounts of money become more attractive as interest rates fall. Since interest rates peaked at about 20% in 1982, they have fallen until the present time. Interest rates are now at lows not seen since the 1950s. Thus bond returns, which averaged annual real returns of 2.2% from 1946 to 2001, rose to provide average annual real returns of 8.5% from 1982 to 2001 as interest rates declined and bond prices rose. In estimating bond returns, the longer period that began shortly after the end of World War II provides a more realistic rate of expected average annual gains. Inflation-adjusted stock returns, by comparison, were 7.1% from 1946 to 2001 and 10.5% from 1982 to 2001. Again, the longer period provides a better target, for it minimizes the influence of the tech boom that exaggerated gains and the subsequent crash which wiped away many of those profits.

In considering the portfolio balance of stocks and bonds, it is useful to examine the periods during which stocks outperform bonds and those during which bonds outperform stocks. Using a very long measuring period from 1871 to 2001, Jeremy J. Siegel, Professor of Finance at the Wharton School at the University of Pennsylvania, has shown that stocks outperform bonds in 61% of single years in that 130 year period, 74% of 5 year periods, 82% of 10 year periods, 95% of 20 year period and 100% of 30 year periods. The investor who needs money a year from the present may want to hold 40% of total assets in bonds. The investor who does not need money for 30 years has no need for bonds and will do far better to be invested fully in stocks.

Stock picking is a much more complex exercise than estimating bond returns. It is especially challenging in a period in which accounting has come into disrepute due to the excesses of Enron Corp., WorldCom (now renamed MCI) and other large companies. Nevertheless, it is possible to examine returns in stocks for those investors who are prepared to accept substantial risk and those who wish to avoid it.