America is a nation of options. Take water for example, you can buy bottled water, water with mineral salts, water without salts, carbonated water, fruit-flavored water, or even water that is infused with oxygen. This example holds true when it comes to investing.
You may walk into your financial adviser’s office with a clear idea of what you want to do. Let’s say you want to save for retirement, and then you are presented with options — do you want long-term investment options? Should you buy bonds? Okay… what kind of bond; interest-paying or non-interest paying? Inflation-indexed? Real Estate backed bonds? Convertible bond? 100-year bonds? The options are endless.
Let us start from a plain vanilla bank savings account. I got Fig 1 below from a J. P. Morgan Asset Management (JPMAM) presentation, and it tracks savings account return from 1994 to 2020. If that investor had put $100,000 into a savings account in 2000, those funds would have earned 6%. Today, however, those same funds put in the same account will only return 0.28% per annum. Keep in mind that inflation in the United States is currently at 0.3%. So, the investors are just barely hanging on in terms of earning a yield.
What if the investor decides to earn a return that is higher than US inflation?
How can the investor beat inflation?
What about bonds?
Well, the US Treasury Bonds are quite safe. The US dollar is also very strong. Can a dollar bond beat inflation? The simple answer is no. Take the 10-year bond yield in Figure 2; the yield has fallen from a high of nearly 5.5% in 2007 to just about 0.74 in 2020. Bond yields move in the opposite direction as interest rates. So, as interest rates in the US fall, bond prices rise, thus yields fall.
Investing in bonds does get the US investor a real rate, but certainly no daylight. How else can the US investor boost his returns to real gains? Keep in mind this desire for yields will necessitate having to expose the portfolio to more volatility (risk). What about equities?
In 2020, the US stock market has been essentially flat, as Figure 3 shows. However, 2020 is an outlier and can be attributed to the economic malaise caused by the COVID-19 shutdown. The annualized return of the S&P 500 index between 1919 and 2019 is 10.47% (dividends included). So, whilst we cannot predict future earning, we can use the average returns as a guide.
So, if that investor was looking at a fixed guaranteed return, with lower risk, the US Treasury Bonds will be the way to go. If, however, the investor wanted to take more risk and potentially grow his capital, investing in the capital market is the way to.
Figure 4. shows the relationship in terms of yield between both asset classes. From 1901 to 1958, the dividend yield earned on US equities exceeds that paid by US bonds. From 1959 to 2008 however, the dividend yield on US Government bonds surpassed that from Equities.
What is happening is simple —as stock prices rise, their dividend yield falls. This is because there is an inverse relationship between the two. Thus, in the earlier part of the century, bonds did not pay a lot in terms of coupons. Therefore, dividend yield from equities outperformed bonds. However, as America raised interest rates in the 1970s to combat inflation, bond yields rose and overtook stock yields. Fast-forward to the year 2007 when the Federal Reserve dropped rates to combat the global financial crises, equity yields again started to do better than bonds.
The lesson from this analysis is clear, and that is the need for investors to know what exactly they seek: returns or yields. While stocks may have outperformed bonds by returns, bonds have beaten stocks in terms of yield earned.
In closing, the asset class with the best return in the US for the last decade has been Real Estate Investment Trusts (REITS).