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May 16, 2009, 4:15 p.m. EDT

Bonds break long-held investing rules

After a 'lost decade,' popular belief in stocks' superiority is under fire

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By John Spence, MarketWatch

BOSTON (MarketWatch) -- Two brutal bear-markets for stocks within a decade and a stunning bull run for government bonds is challenging the gospel that stocks will always beat bonds if investors just hold on long enough.

Now, Rob Arnott, a veteran financial analyst and market pundit, has lobbed the academic version of a Molotov cocktail at one of the most sacred tenets of investing.

"For the long-term investor, stocks are supposed to add 5% a year over bonds. They don't," Arnott, founder of investment consultants Research Affiliates and former editor of the Financial Analysts Journal, wrote in a paper published in the latest Journal of Indexes.

"Indeed," Arnott contended, "for 10 years, 20 years, even 40 years, ordinary long-term Treasury bonds have outpaced the broad stock market."

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Investors Are Feeling The Stress

The stock market should remain choppy as investors fret about banks, the consumer, and even the president. Barron's Steven M. Sears reports.

For shell-shocked stock investors, Arnott raises the crucial question of whether stocks or bonds are the best place to protect and grow their nest egg.

And by challenging an idea that's become conventional wisdom, he's stirred up a hornet's nest in the world of finance.

"I don't think government bonds are where you want to be now," counters Jeremy Siegel, a finance professor at the Wharton School. His best-selling book, "Stocks for the Long Run," is seen as one of the driving forces behind the popularity of equity investing.

This public duel between two well-known names in finance is being played out after the Standard & Poor's 500 Index /zigman2/quotes/210599714/realtime SPX -4.41% plunged almost 40% in 2008, while long-term government bonds surged more than 20% as investors scrambled for safety.

Through Thursday's close, the S&P 500 was roughly even so far this year, but up about 34% from its March 6 intraday low. A debate rages over whether the bounce is a bear-market rally or the beginning of a new bull market for stocks.

Lost decade(s)

Arnott, whose challenges to traditional stock-indexing strategies and own line of specialized exchange-traded funds have made him no stranger to controversy, appears to relish tweaking defenders of the faith of stock investing.

"Most observers, whether bond skeptics or advocates, would be shocked to learn that the 40-year excess return for stocks, relative to holding and rolling ordinary 20-year Treasury bonds, is not even zero," Arnott wrote. Read Arnott's article .

Investors will "become increasingly aware that the conventional wisdom of modern investing is largely myth and urban legend," he predicted.

/zigman2/quotes/210599714/realtime SPX 2,470.50, -114.09, -4.41%
$SPX

With two sharp corrections during the past decade -- the dot-com crash and the more recent credit crunch -- investors in U.S. stocks are underwater.

Through the end of April, the 10-year annualized return on the S&P 500 was negative 2.5%, according to Standard & Poor's.

Meanwhile, an index fund tracking long-term U.S. Treasury bonds, Vanguard Long-Term Treasury Fund /zigman2/quotes/201786083/realtime VUSTX +1.47% , gained 7.2% annualized over the same period.

"People fret about our 'lost decade' for stocks, with good reason, but they underestimate the carnage," Arnott wrote.

Arnott's research shows that starting at any point from 1979 through the end of 2008, an investor in 20-year Treasurys who continually rolled over into the nearest bond and reinvested the income would have come out ahead of the S&P 500.

'Where's our birthright ... our 5% equity risk premium?'

-- Rob Arnott, Research Affiliates

"In fact, from the end of February 1969 through February 2009, despite the grim bond collapse of the 1970s, our 20-year bond investors win by a nose," he wrote. "We're now looking at a lost 40 years!"

Yet stock investors are told there are rewards for going out on a limb. The so-called risk premium of stocks is a more elegant way of saying "no guts, no glory."

Essentially, when investors buy stocks, they expect to earn return above "safer" government bonds. In other words, they anticipate being compensated for purchasing riskier, more volatile assets.

/zigman2/quotes/210599714/realtime
US : S&P US
2,470.50
-114.09 -4.41%
Volume: 3.67B
April 1, 2020 5:09p
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/zigman2/quotes/201786083/realtime
US : U.S.: Nasdaq
$ 15.87
+0.23 +1.47%
Volume: 0.00
April 1, 2020
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