Ibbotson says bonds have done unusually well in recent years because of peculiar conditions. When interest rates fall, bond prices rise, and that's what happened beginning in the 1980s. Rates on 10-year Treasuries dropped from 15.6% in October 1981 to 2.08% in December 2008. During the 20 years beginning in 1982, long governments set a record, returning 12.1% annually.
With Treasuries currently yielding 3.29%, bond investors can't possibly benefit from another period when rates record double-digit declines, Ibbotson says. Chances are investors will collect interest payments in coming years and get little or no capital gains. That means bonds will produce total returns of 3% to 4% in the future.
Stocks should do considerably better. Estimating the future total returns of stocks, Ibbotson says share prices tend to rise along with earnings. If earnings grow at the historic annual rate of 5%, prices can appreciate by that much. In addition, investors will also collect dividends. The dividend yield on the S&P 500 is currently around 2%. The total of dividends and capital gains should result in annual returns of about 7%.
Ibbotson concedes that earnings could be subpar. But he says that if earnings only grow at a 2% rate, stocks would still outperform bonds. Stocks can only lag if the S&P 500 suffers a massive decline, with the price-earnings ratio falling to 5, a huge drop from the 20-year average of 20.
Despite his bullish outlook on stocks, Ibbotson advocates holding some bonds for diversification. Bonds can help to limit risk while only reducing expected returns slightly. A portfolio that included 30% long-term government bonds and 70% in the S&P 500 would have returned 8 .9% annually during the 83 years ending in 2008, Ibbotson found. In comparison, a portfolio that was 100% in the S&P 500 would have returned 9.6% while taking much more risk than a portfolio that included bonds.