Time to Dump Stocks and Buy Bonds?

Many people are questioning the effectiveness of long-term stock investing after the steep drops of the past two bear markets. Conventional wisdom holds that equities consistently outperform bonds when held for 20 or more years, with only slightly more risk.

But some experts claim that bonds deserve a second look, pointing to the 38% decline of stocks in the past 18 months. They argue that bond-only portfolios can provide returns that are comparable to or even greater than those of equities without the price gyrations.

Bonds look pretty darn appealing these days. The Barclays Capital Aggregated Bond Index has returned 5.2% a year in the five years through May 11, while the S&P 500 Index has lost an average of 1.7%. On average, bonds have also outperformed broad stock indexes during the past 10 years.

Michael Herbst, an analyst with Chicago-based research firm Morningstar ( MORN), recommends that investors keep the unique circumstances of the past year and a half in mind when comparing fixed-income and equity returns.

"Last year was one of the worst years on record for the S&P and one of the best years on record for the bond index," Herbst says. "Government bonds aren`t going to look great when the stock market is rallying, but they'll often look a lot better when stocks tank."

Investors buy bonds as a source of income and to diversify their portfolios, which helps protect them from the ups and downs of stocks, Herbst says. That's assuming your portfolio relies on stocks to drive its growth.

Hildy and Stan Richelson of Scarsdale Investment Group in Blue Bell, Pa., have been creating bond-only portfolios for clients for 25 years. In their book, Bonds: The Unbeaten Path to Secure Investment Growth (Bloomberg Press 2007), the Richelsons argue that investors can achieve portfolio growth without owning stocks if they use bond-generated income to buy more bonds.

"Think of the income not as income but rather as something to reinvest," Stan Richelson says. "That will give you growth."

The Richelsons doubt the common assumption that stocks deliver higher returns than bonds over time. They point to a recent article by quantitative investor Robert Arnott in the Journal of Indexes to bolster their case. Arnott claims that "starting any time we choose from 1979 through 2008, the investor in 20-year Treasuries (consistently rolling to the nearest 20-year bond and reinvesting income) beats the S&P 500 investor." Arnott compared the performance of U.S. stocks and bonds from 1801 to February 2009, concluding that bonds beat stocks in 129 out of the 208 years.

Stan Richelson says there's no need to take on the inherent risks of equities when high-grade bonds can deliver returns on a reliable schedule. Investors also shouldn't assume that equities will outperform fixed income in the future just because they did in the past.

"People used to criticize us for not diversifying, but here we are in 2009 with everyone taking losses and we didn't take losses because we didn't diversify," Richelson says.

So, should you switch to bonds? Morningstar's Herbst says there could be serious downsides for investors who fill their portfolios with fixed income now. The future performance of bonds will depend on the pace of economic recovery, inflation and the amount of debt issued by the government.

"It's understandable why people might be tempted to do that, but there's always the risk of getting the timing wrong," he says. "Moving 100% into bonds means you don't stand to gain at all from how the stock market recovers."

Zack Anchors is a freelance writer from Portland, Maine.

More from Personal Finance

What Is Cryptocurrency? Everything You Need to Know

What Is Cryptocurrency? Everything You Need to Know

How to Read a Balance Sheet

How to Read a Balance Sheet

How to Become a Millionaire by 25

How to Become a Millionaire by 25

What Is a 403(b) Plan and How Do You Contribute?

What Is a 403(b) Plan and How Do You Contribute?

3 Keys to Being a Financial Planner

3 Keys to Being a Financial Planner