NEW YORK ( TheStreet) -- When their stock portfolios melted away last spring, some investors fumed at the research done by Roger Ibbotson. The founder of Ibbotson Associates was one of the first to argue that stocks outperformed bonds over long periods. During the bull market of the 1990s, brokers decorated their offices with the famous Ibbotson charts, which showed that stocks rose relentlessly over the decades. That led countless investors to put most of their holdings in stocks. But as markets collapsed in the first quarter of this year, the long-term results changed. For the previous four decades, bonds had outdone stocks. Complaining that the Ibbotson data had been misleading, investors began lowering their stock allocations. Though his findings may have come under assault, Roger Ibbotson remains undeterred. He recently published an upbeat assessment, arguing that stocks will beat bonds by a significant margin in the future. Those who scoff at Ibbotson's thinking should recall his first attempt at predicting market returns. The forecast came in 1974, a year when the Dow Jones Industrial Average was stuck at 800 in the middle of a brutal bear market. Ibbotson and his colleague Rex Sinquefield said the Dow would hit 10,000 by November 1999. The forecast seemed laughable at the time, but it proved dead-on when the Dow hit that mark in March 1999. In his recent publication, Ibbotson notes that the performance of stocks during the past 40 years has actually been quite good. While bonds edged ahead in February, stocks resumed their lead soon after the rally began in March. During the 40 years ending in June, the S&P 500 Index returned 9.2% annually, compared with 8.5% for long-term bonds.
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.
To employ Ibbotson's thinking, consider buying a balanced fund that holds a mix of stocks and bonds. A fund that keeps about 70% of assets in stocks and the rest in fixed income is Franklin Templeton Growth Target ( FGTIX - Get Report), which has returned 4.2% annually during the past decade, outdoing 85% of its moderate-allocation competitors, according to Morningstar. Franklin invests in a collection of mutual funds, including the top-performing Mutual Shares ( TESIX - Get Report). Another equity-heavy balanced fund is T. Rowe Price Balanced ( RPBAX - Get Report), which has returned 3.5% annually during the past decade, outperforming 73% of competitors. The fund holds high-quality bonds and blue chips, such as Apple ( AAPL - Get Report) and Johnson & Johnson ( JNJ - Get Report).