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Stocks vs. Bonds: A Risk Scoreboard

By: Abby Schultz
New York Times, June 30, 2002

Investors these days are painfully aware that stock prices can plunge as easily as they can soar. Still, many people have comforted themselves with a market truism: that in the long run, stocks outperform other asset classes.

A new study by Moody's Investors Service, however, notes a more sobering truth: that the stock market is very risky. It has been so volatile, in fact, that when swings in market prices are factored in, corporate bonds outperformed stocks on a risk-adjusted basis from Jan. 1, 1990 to the end of May this year.

"So many people are infatuated with the equity markets, but to earn that return you'd have to accept a lot of risk," said John Puchalla, a senior economist at Moody's.

The study was based on the work of William F. Sharpe, a Nobel laureate and an emeritus professor of finance at Stanford, who developed a method to compare returns of asset classes on a risk-adjusted basis.

The point of such findings, Professor Sharpe said in an interview, is not that bonds should be favored over stocks, but that portfolios should be diversified among asset classes and that investors should consider how the risk and return characteristics for one type of asset relate to those for others in an investment portfolio.

"If you are looking at bonds and stocks as parts of a portfolio, what you need to figure out are the returns and risk and the correlation between them," said Professor Sharpe, who is also chairman of Financial Engines, a company that supplies technology for financial analysis to retirement plans and asset managers.

The method of analyzing risk-adjusted return, known as the Sharpe ratio, is a fundamental of modern portfolio theory, an influential approach to investing. The theory was developed in part by Harry M. Markowitz, emeritus professor of finance at Baruch College of the City University of New York, and by Professor Sharpe, who were two of the three recipients of the Nobel in economic science in 1990. The theory holds that by investing in an array of asset classes, investors can maximize return for the risk they are willing to bear. It underlies the guidance provided today by most financial advisers.

"Different major asset classes respond differently to world economic events," said Roger C. Gibson, an adviser in Pittsburgh. "As a result of that, they generate different patterns of return." By combining assets, like stocks and bonds, the ups and downs, or volatility, can be reduced for the overall portfolio, Mr. Gibson said.

The Moody's analysis helps explain why bonds would have mitigated the wild swings in many portfolios in recent years.

The Sharpe ratio, the basis of the study, is a mathematical formula involving terms that may be unfamiliar to many investors. Here is how it works: First, it takes into account the return that an investor can receive without taking any risk. The Moody's study used the average monthly returns of a 90-day Treasury bill — considered a risk-free asset.

The risk-free return is then subtracted from the return of the asset being analyzed. The difference is called the excess return. To figure the Sharpe ratio, excess return is divided by the investment's standard deviation — a statistical measure of volatility.

The ratio describes how much return an investment is likely to provide for the risk of holding it. The higher the ratio, the more an investor is likely to be rewarded for taking on risk.

Someone who could bear the risk — and remain fully invested in a diversified stock portfolio — during the years in the Moody's study would have made more money than someone invested entirely in corporate bonds. The stocks in the Standard & Poor's 500 index had an annualized total return of 12.2 percent from Jan. 1, 1990, through May 31, compared with 8.4 percent for bonds.

The Sharpe ratio, however, emphasizes another part of the story. Mr. Puchalla calculated that the Sharpe ratio of the S.& P. 500 was 0.15 from Jan. 1, 1990, through May 31, while the ratio for investment-grade corporate bonds, based on returns estimated by Moody's, was 0.20. Taking risk into account, in other words, corporate bonds outperformed stocks.

A separate study, using even longer-term data, yielded similar results. On a risk-adjusted basis, using the Sharpe ratio, long-term corporate bonds outperformed stocks from 1926 through the end of May 2001, according to Ibbotson Associates, a research firm in Chicago.

Over shorter periods, a variety of asset classes may shine on a risk-adjusted basis. Taking risk into account, the S.& P. 500 did better than the Lehman Brothers Aggregate Bond Index from 1990 to 1999, for instance, as well as from 1980 to May this year, said Kurt Winkelmann, co-head of global investment strategies at Goldman Sachs Asset Management, which recently conducted research on the subject.

From 1990 to 1997, however, the asset class with the highest Sharpe ratio was high-yield bonds tracked by the Lehman Brothers Aggregate Bond Index, Mr. Winkelmann said.

None of the researchers, however, say the use of risk-adjusted returns should make investors abandon any one asset class and load up entirely on another.

In fact, to invest strictly by limiting risk would lead to a lopsided portfolio that is fitting only for an investor with a short time horizon, said Peter Di Teresa, senior analyst at Morningstar. Of all the mutual funds tracked by Morningstar, 7 of the 10 with the highest Sharpe ratios are short-term bond funds, Mr. Di Teresa said. The other three are a high-yield bond fund, a small-cap stock fund that uses options to reduce risk, and a real estate fund with a high income stream, according to Morningstar. Holding a group of these funds alone would not make much sense, he said.

Instead of using one statistical measure to choose a portfolio, an investor should consider how much risk he is willing to take before assembling it. An investor with a shorter-term goal like paying for a child's college education would take on less risk than a young investor beginning to save in a retirement plan.

"Once we pin down that risk level, then we can focus on the bond-equity split," Mr. Winkelmann of Goldman Sachs said. "From our view, portfolios should have a broader exposure to an array of asset classes."

In building a portfolio of various assets, investors should avoid those that are perfectly correlated, he said. This means their prices should not rise or fall in tandem.

Stocks and bonds have a correlation of about 0.3 to 0.5 on a scale ranging from minus 1.0 to plus 1.0, Professor Sharpe said. "That means that more than not, good months for bonds are good months for stocks, but there are a whole lot of exceptions," he said. A basic, diversified portfolio should have a mix of about 60 percent stocks and 40 percent bonds; from there, the mix of stocks and bonds depends on the investor's risk tolerance, he added.

 
R. GIBSON, the financial adviser in Pittsburgh, counsels all his investors to buy some bonds, even if they have a long-term horizon and a high tolerance for risk. He tells them that bonds may reduce their long-term returns but that the stabilizing effects of bonds will make them less likely to sell if the stock market drops precipitously. If investors include bonds, he said, "They have greater staying power."

This argument is easier for many investors to accept after the stock market's performance in the last couple of years. In the 20 years ending in 1999, at the height of the bull market, stocks had experienced only two down years, 1981 and 1990, Mr. Gibson said. That was unusual. Data going back to 1926 shows that stocks fell in 3 of every 10 years, on average, he said.

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