Chapter One
Bonds Are Safer Than Stocks

“Everyone knows bonds are safer than stocks.”

EVEN AFTER 2022’S BOND beatdown, that belief remains asset orthodoxy – a 100%, take-it-to-the-bank, of-course-the-sky-is-blue truism. After all, bonds still beat stocks in their atypically terrible 2022. Even investigating the idea stocks could be safer seems sacrilegious.

But beliefs so widely, broadly, universally held are often those that end up being utterly wrong – even backward.

So go ahead. Ask, “Are bonds safer?”

Initially, it may seem intuitive that typically plodding bonds are safer than stocks with their inherent wild wiggles. But I say, whether bonds are safer or not can depend on what you mean by “safe.”

There’s no technical definition – and huge room for interpretation. For example, one person might think “safe” means a low level of expected shorter-term volatility. No wiggles! Another person might think “safe” means an increased likelihood he achieves long-term goals, which may require a higher level of shorter-term volatility.

Bonds Are Volatile, Too

In 2022, many people learned the hard way that stocks aren’t the only asset with negative volatility – bonds wiggle, sometimes downward, as well! But that is nothing new. Bonds have always had price volatility. Their prices move in inverse relationship to interest rates. When interest rates rise, like in 2022, prices of currently issued bonds fall, and vice versa. So from year to year, as interest rates for varying categories of bonds move up and down, their prices move down and up. Some categories of bonds are more volatile than others – but in any given year, bonds can have negative returns – even benchmark US Treasurys, which plunged −17.0% in 2022.1

But overall, as a broader category, bonds typically aren’t as volatile as stocks – over shorter time periods.

That’s an important caveat. Over shorter time periods like a year or even five, bonds are less volatile. They have lower expected returns, too. But if your exclusive goal is mitigating volatility, and you don’t care about superior long-term returns, that may not bother you.

Exhibit 1.1 shows average annual returns and standard deviation (a common measure of volatility that shows the difference from the average return) over five-year rolling periods. It’s broken into a variety of allocations, including 100% stocks, 70% stocks/30% fixed income, 50%/50% and 100% fixed income.

Exhibit 1.1 Five-Year Time Horizon – Volatility

*Standard deviation represents the degree of fluctuations in historical returns. This risk measure is applied to five-year annualized rolling returns in the chart.

Source: Global Financial Data, Inc., as of 2/21/2024. US 10-Year Government Bond Index, S&P 500 Total Return Index, average rate of return for rolling five-year periods from 12/31/1925 – 12/31/2023.

Returns were superior for 100% stocks. And, not surprisingly, average standard deviation was higher for 100% stocks than for any allocation with fixed income – stocks were more volatile on average. The more fixed income in the allocation over rolling five-year periods, the lower the average standard deviation.

So far, I haven’t said anything that surprises you.

Everyone knows stocks are more volatile than bonds.

Stocks Are Less Volatile Than Bonds?

But hang on – if you increase your observation period, something happens. Exhibit 1.2 shows the same thing as Exhibit 1.1, but over rolling 20-year periods. Standard deviation for 100% stocks fell materially and was near identical to standard deviation for 100% fixed income. Returns were still superior for stocks – but with similar historic volatility.

Exhibit 1.2 20-Year Time Horizon – Volatility

*Standard deviation represents the degree of fluctuations in historical returns. This risk measure is applied to 20-year annualized rolling returns in the chart.

Source: Global Financial Data, Inc., as of 02/21/2024. US 10-Year Government Bond Index, S&P 500 Total Return Index, average rate of return for rolling 20-year periods from 12/31/1925 – 12/31/2023.

It gets more pronounced over 30-year time periods – shown in Exhibit 1.3. (If you think 30 years is an impossibly long investing time horizon, Chapter 2 is for you! Investors commonly assume a too-short time horizon – a 30-year time horizon likely isn’t unreasonable for most readers of this book.) Over rolling 30-year periods historically, average standard deviation for 100% stocks was lower than for 100% fixed income. Stocks had half the volatility but much better returns!

Exhibit 1.3 30-Year Time Horizon – Volatility

*Standard deviation represents the degree of fluctuations in historical returns. This risk measure is applied to 30-year annualized rolling returns in the chart.

Source: Global Financial Data, Inc., as of 2/21/2024. US 10-Year Government Bond Index, S&P 500 Total Return Index, average rate of return for rolling 30-year periods from 12/31/1925 – 12/31/2023.

Day to day, month to month and year to year, stocks can experience tremendous volatility – often much more than bonds. It can be emotionally tough to experience, but that higher shorter-term volatility shouldn’t surprise you. Finance theory says it should be so. To get to stocks’ long-term superior returns over fixed income, you must accept a higher degree of shorter-term volatility. If stocks were less volatile year to year on average, their returns would likely be lower. Like bonds!

But given a bit more time, those monthly and yearly wild wiggles resolve into steadier and more consistent upward volatility. And yes, volatility goes both ways. You probably don’t hear this often (if ever), but data prove stocks have been less volatile than bonds historically over longer periods – and with superior returns.

Blame Evolution

If that’s the case, why do so many investors fear stocks? Easy: evolution.

It’s been proven that investors feel the pain of loss over twice as intensely as they enjoy the pleasure of gain. That’s from the Nobel prize-winning behavioral finance concept of prospect theory. Another way to say that is it’s natural for danger (or perceived danger) to loom larger in our brains than the prospect of safety.

This evolved response no doubt treated our long-distant ancestors well. Folks who naturally fretted, constantly, the threat of attack by saber-toothed tigers were likely better off than their more lackadaisical peers. (The best way to win a fight with a saber-toothed tiger is not to get into one.) And those who had an outsized fear of the coming winter likely prepared better and faced lower freezing and/or starvation risk. Hence, they more successfully passed on their more vigilant genes. But obsessing about future pleasantness or the absence of freezing risk didn’t really help perpetuate the species.

Our basic brain functioning just hasn’t changed that much in the evolutionary blink-of-an-eye since. Which is why the research shows a 10% portfolio loss feels about as bad to US investors on average as a 25% gain feels good. (European investors feel the pain of loss even more intensely.)

Stocks Are Positive Much More Often Than Not

What does that have to do with the common misperception stocks are just down a lot? Exhibit 1.4 shows how often stocks are positive versus negative over varying time periods. On a daily basis, the odds stocks are positive are slightly better than a coin flip. And negative days tend to come in clumps. Positive days, too! But because we’re hyper-aware of danger, the negative clumps loom larger in our brains, even though that isn’t reality.

Behaviorally, it can be very difficult not to think so short term. But if you can stretch your observation period just a bit longer, odds are good stocks will be positive. Stocks are positive historically in 62.9% of calendar months – though they come in clumps, too. Rolling 12-month periods are positive 75.0% of the time. And yet, headlines and pundits hyperventilate as if there’s a bear market perpetually lurking around every corner. What they should really fear is missing market upside (see Chapter 3), but that isn’t what comes naturally to our brains – which aren’t all that different from our distant ancestors’ caveman brains.

Exhibit 1.4 Stocks’ Historical Frequency of Positive Returns