Forget What You Know about Stock Returns

Many advisors use historical data to project expected returns for U.S. stocks and bonds. But a close look at the historical data suggests that the excess performance of stocks relative to bonds occurred mainly in two historical periods and has been much less consistent over the last 25 years. Advisors illustrating the decision to increase investment risk to fund future goals should acknowledge the possibility that the historical equity risk premium may be lower – indeed, low enough to no longer be considered a puzzle by financial economists.

We’ve all seen the graph that compares historical stock and bond performance since 1926 using Ibbotson/Morningstar data:

The graph shows the dramatic performance of stocks compared to bonds over the last 95 years. Advisors show the graph to clients to explain why increasing investment risk pays off over the long run, and how they can provide value by creating portfolios that harness the power of equities.

The outperformance of stocks over bonds is a mystery to financial economists who refer to it as the “equity premium puzzle.” Between January 1926 and June 2022, the arithmetic average return on the S&P 500 was 11.43%, while the average return on intermediate-term Treasury bonds was 4.91% and T-bills returns were just 3.2%. Richard Thaler, who recently won a Nobel Prize in economic sciences, co-authored a widely-cited paper in 1995 that explained low stock ownership among individual investors as a behavioral anomaly driven by the tendency to focus on short-term losses rather than long-term excess performance. In other words, by helping investors manage short-term volatility and focus on long-term growth, advisors could help their clients capture puzzlingly high investment returns.