Rob Arnott in Journal of Indexes – Bonds: Why Bother? |

Rob Arnott in Journal of Indexes – Bonds: Why Bother?

In case you’ve missed it or haven’t seen it yet, Rob Arnott, whose work I greatly admire has once again thrown in his 2 cents: http://www.indexuniverse.com/publications/journalofindexes/articles/149-may-june-2009/5710-bonds-why-bother.html. In this piece, Arnott argues that contrary to Modern Portfolio Theory, Efficienct Markets, or most common investing knowledge, the equity risk premium is not what you’d expect. He goes through a historical analysis of the past 40+ years to show that in that time, government Treasury bonds have outperformed stocks on rolling multi-decade periods, which suggests the anticipated 5% equity risk premium is in fact not there.

While Jeremy Siegel, another academic whose work I admire and famous author of Stocks for the Long Term, is coming out and disagreeing based on some technicalities such as end-point sensitivity, ideas of long term, etc. I actually don’t think either of these guys would disagree with the other on a fundamental principle we’ve discussed before: the price at which an asset is bought will dictate its future long term return potential. All else being equal, paying up for assets tends to be a mistake. I’ll take this a step further, risk is NOT rewarded, and in fact it is the opposite. This takes MPT and turns it on its head, but the numbers bear out.

Consider the academics perspective: Assuming you are a rational person, the only reason to take a large risk would be to achieve a larger return. Risk, in this case is measured by volatility and after some mathematical calculations of correlation, the academic actually comes out with a number, called beta for each stock. The beta of a stock measure the stocks sensitivity to movements in the overall market. Well, in a theoretical world, more risk (higher beta) should lead to higher returns. Yet, in reality, we see that lower beta stocks tend to outperform high beta stocks (see the works of Lakonishok, Greenblatt, Montier, Famma and French, etc.).

Arnott simply hit on a time period in which buying overpriced stocks did not produce the desired return over the risk-free rate of bonds. Not surprising considering that his starting point is the bubble period of the late 60′s. The real question is whether buying bonds now with a yield of 3-4% will provide the outsized returns relative to stocks. The next question is which stocks. If you focus on underpriced stocks to begin with, which should have outsized returns relative to the equity market in general anyway, then bonds look even less attractive. I think Arnott would tend to agree. His point is that beginning valuations do matter. It is not about simply saying “timing the market is impossible”, but rather recognizing that there are better times ON AVERAGE to invest in different asset classes. I doubt he would say that one of those times is now for bonds.

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