One of the greatest fallacies of investing is the dependence on historical data and returns for the basis of investment decisions.  You will often hear  investors saying, “over the long-run stocks always beat bonds!”  Recently, the opposite has been said because bond returns have trumped stocks in the last 30 years.  This must mean that bonds are better investments than stocks right?  These are false conclusions.  What really matters is what is going to happen in the future, not what happened in the past.

With regards to the latter observation, that bonds have beat stocks over the last 30 years my response is the following:

The Ten Year Treasury Yield moved from nearly 16% to 2%

Obviously when you start off with treasuries yielding high teen annual interest, 30 subsequent years of a dis-inflationary environment are going to be very beneficial to bond returns.  The problem is that we cannot extrapolate out this return pattern as yields are bounded below by zero percent.   We certainly hope that the treasury is not going to take money away from bondholders for holding the securities by crediting negative interest rates…wait, they actually will do that if inflation is sparked!  The best case scenario for bondholders is that we enter a deflationary scenario akin to Japan’s in which the ten year falls below 1%.  The Japanese scenario is not the basket that I want to put all of my eggs in.

So if nominal bonds are not the answer then stocks must certainly be the key.  Rob Arnott from Research Affiliates goes even further and suggests that both bonds and stocks benefited from the disinflationary environment:

“Even after the “Lost Decade,”1 the 30-plus year period from 1980 through June 2010 witnessed U.S. stocks and bonds returning 10.8% and 8.8% respectively, delivering a 10.3% annualized return for the prototypical 60/40 investor”

Unfortunately, we cannot count on the historical environment to hold true because, “the economic backdrop is likely to see reflation, not disinflation, compromising our ability to earn solid real returns and compromising the spending power of our eventual withdrawals.”

The issue that we need to question is what will the next 30 years look like?  For myself and Rob Arnott, we feel that the future is much more likely to see inflation rather than deflation, or reflation versus disinflation.  With debt burdened developed economies, the path to salvation is much easier through controlled inflation (though many would suggest a controlled level is unachievable).

What Rob rightly questions is where investors can look for inflation protection.  The sad truth is that about 70% of 401(k) options are simple stock funds while the rest are simple bond funds.  Stocks can provide decent inflation protection, but they should not be our only quiver available.

Rob suggests four key components:

“1. Inflation-fighting assets such as TIPS, REITs, and commodities should be blended into the portfolio in a meaningful way.

2. Non-dollar assets should be used on a scale large enough to protect against any government choices that may debase the dollar. Of course, Japan and Europe face the same “3-D Hurricane” that we face here, only more so. So, these non-dollar investments should be in the emerging markets, in the local currencies. It bears mention that the emerging markets largely shrugged off the “global financial crisis” and the “great recession.” Why? Most did not have massive debt. Most did not respond to the crisis with massive deficit spending and new debt. And most chose to let failing enterprises fail instead of propping them up.

3. There should be investments in inflation “stealth fighters” such as high-yield bonds, bank loans, convertibles, and local currency emerging markets debt.  Inflation stealth fighters work in a subtle way. Inflation reduces the real value of the debts, improving debt coverage ratios. As the coverage ratios improve, the credit spread can narrow creating capital gains on top of the original rich yields. This leads to startlingly high correlations between their returns and the rate of inflation.

4. Tactical allocations among the asset class choices. Higher inflation breeds volatility which, in turn, breeds opportunities to be tactical in response to price dislocations. This includes the ability to invest in absolute return, low beta, alpha-oriented strategies for times when both traditional and real return funds offer meager risk-adjusted returns.”

Rob has addressed the true investment question going into the next 30 years, so I hope you are able to stop asking whether stocks or bonds will outperform and start looking at what you can add to your portfolio mix going forward.

Read Rob’s full white paper here: [Download not found]