Stocks Vs. Bonds -- A Radical New Look at an Old Question

Sometimes, you hear the most radical things in the most conventional of places.

That happened to me today when I heard a provocative analysis of the stock market at The Plaza Hotel, of all places. The occasion was a well-attended forum for institutional investors presented by Robert Arnott, managing partner at First Quadrant, an investment firm, and by Ronald Ryan, president of Ryan Labs, which advises pension funds. The forum was essentially an extended discussion of a research paper by Arnott and Ryan called, "The Death of the Risk Premium: Consequences of the 1990s".

The report asks an important and disturbing question for all investors: Will the return on stocks beat the return on bonds over the next 10 to 20 years? This may seem an alarming question to pose given that, in our lifetime, stocks always have beaten bonds. But, in light of this market's record high valuations and the relatively high real yield for bonds, it's surprising that more folks on Wall Street have not asked this question out loud. After all, if you are a stock investor -- and who isn't -- then the answer to this question may determine a good deal of your investment returns over the next two decades.

When Arnott and Ryan talk about "risk premium," they simply mean the superior return stocks must offer investors in order to attract money that would otherwise flow into bonds. The notion is that stocks must offer more because they are more volatile than bonds and because the stock investor is less assured of getting his or her money back than is the bond investor. "Stocks have outpaced bonds by about 5% per annum for a 74-year span and have produced real returns [i.e., adjusted for inflation] north of 7% for an entire century." ...