There are many myths about investing. One of the most popular myths is that “Stocks always beat bonds.” Therefore, the thinking goes, investors should overweight stocks in their investment portfolio if they want to generate higher returns. 

Well, as Harry Browne would have said: “The best kept secret in the investing world: Almost nothing turns out as expected.”

When I was restructuring my investments several years ago and considering the Permanent Portfolio I did quite a bit of my own research. And you know what I found? Stocks in fact do not always beat bonds. Or, I should say, they don’t always beat bonds on your particular time table. 

Sure, perhaps if you look back 200 years you can make a case that stocks have a better chance of beating bonds. After all, there is more risk so theoretically there is more reward. But individual investors don’t have a 200 year time horizon. Most don’t have even a 50 year time horizon. For many people their investment horizon before they need that money for retirement purposes is more like 20 to 40 years. When you look at time slices of the market from this perspective it is clear that stocks can in fact lose to bonds in total returns.

Recently, researcher Robert Arnott looked back over the last 40 years and discovered that during this time (when you factor in 2008′s abysmal performance) that bonds in fact did beat stocks. He wrote about it in the article: Bonds: Why Bother?

Now I think he’s using some data mining to make his point, but it’s still something interesting to consider.

This image summarizes his findings that bonds have in fact beat stocks over extended periods of time in US history:

Can bonds beat stocks? Sure they can. Image Source: Index Universe

Other points Arnott found were:

• From 1803 to 1857, stocks floundered, giving the equity investor one-third of the wealth of the bond holder; by 1871, that shortfall was finally recovered. Oh, by the way, there was a bit of a war—or three—in between. Forget relative wealth if you owned Confederate States of America stocks or bonds. Most observers would be shocked to learn that there was ever a 68-year span with no excess return for stocks over bonds.
• Stocks continued their bumpy ride, delivering impressive returns for investors, over and above the returns available in bonds, from 1857 until 1929. This 72-year span was long enough to lull new generations of investors into wondering “why bother with bonds?” Which brings us to 1929.
• The crash of 1929–32 reminded us, once again, that stocks can hurt us, especially if our starting point involves dividend yields of less than 3 percent and P/E ratios north of 20x. It took 20 years for the stock market investor to loft past the bond investor again, and to achieve new relative-wealth peaks.
• Then again, between 1932 and 2000, we experienced another 68-year span in which stocks beat bonds reasonably relentlessly, and we were again persuaded that, for the long-term investor, stocks are the preferred low-risk investment. Indeed, stocks were seen as so very low risk that we tolerated a 1 percent yield on stocks, at a time when bond yields were 6 percent and even TIPS yields were north of 4 percent.
• From the peak in 2000 to year-end 2008, the equity investor lost nearly three-fourths of his or her wealth, relative to the investor in long Treasuries.

What Arnott re-confirms is that the reality of investing is this: Assets you think should outperform in a market may not do so for quite some time. He also stated:

In our asset allocation work for North American clients, we model the performance of 16 different asset classes. In September 2008, how many of these asset classes gave us a positive return? Zero. How often had that happened before in our entire available history? Never.

Isn’t it amazing how many things that are never supposed to happen in investing do happen more than anyone ever thought possible? That’s one of the things I loved about Harry Browne’s writing and investing philosophy: He never took the unexpected for granted.

How this relates to the Permanent Portfolio is simple: You should hold a portfolio of diversified assets and not try to predict what the future is going to bring. Inside this framework you need to be sure you rebalance your asset allocation periodically. This allows you to capture gains and buy out-of-favor assets before the masses in the market move in to run up the prices in a fit of euphoria or fear. 

With respect to the Permanent Portfolio, your bonds should only be US Treasury Long Term Bonds. They were selected for a reason (no credit risk and powerful returns under deflation) and proved their worth in 2008 saving the portfolio from suffering any serious loss. If you want to find out why you should only hold US Treasury Bonds in the portfolio (or any portfolio), please see the Bond FAQ. 

Just remember that myths such as “Stocks always beat bonds” may not be true when you need it to be. It may be that stocks are going to outperform bonds, cash and gold in the portfolio going forward. But then again they may not. The better strategy is to hold a balanced and diversified portfolio so you can profit no matter what the future brings.