If you like the idea of lower volatility, shallow losses in bear markets and higher long-term returns, buy high-quality, dividend-paying stocks
Stocks are the big winner when it comes to long-term returns. Photo by Michael M. Santiago/Getty Images In times of volatility, stocks get a bad rap. But they are the undisputed champion by a country mile when it comes to long-term returns.
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In his book Stocks for the Long Run, Jeremy Siegel, a professor at The Wharton School of the University of Pennsylvania, states, “Over long periods of time, the returns on equities not only surpassed those of all other financial assets but were far safer and more predictable than bond returns when inflation was taken into account.”
As the following table demonstrates, stocks have outperformed bonds, but they’ve also trounced other major asset classes. Any diversification away from stocks over extended holding periods has resulted in vastly inferior portfolio performance.
The all-stock portfolio: Better in theory than in practice The preceding table begs the question: why don’t all investors just hold all-stock portfolios? There are valid reasons that render such a strategy less than ideal for many investors.
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Article content The 100-per-cent stock portfolio is a double-edged sword. If you can 1) stick with it through stomach-churning bear market losses, 2) have a (very) long-term horizon, and 3) don’t need to sell assets for any reason, then strapping yourself into the roller coaster of a 100-per-cent stock portfolio may indeed be the optimal solution. Conversely, it would be difficult to identify a worse alternative for those who do not meet these criteria.
With respect to the emotional fortitude required to stand pat through bear markets, there is considerable evidence that many investors are simply incapable of doing this. One of the best illustrations of this fact is Fidelity Investments Inc.’s flagship Magellan Fund, under the stewardship of legendary investor Peter Lynch. From May 1977 to May 1990, Lynch managed to achieve an annualized return of 29.06 per cent as compared to 15.52 per cent for the S&P 500 index. However, the average investor in the fund lost money during this period.
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Article content Many Magellan investors hopped on board when the fund was soaring and then jumped ship during difficult periods. This all-too-common misfortune is well-depicted by the following illustration from Behavior Gap, which demonstrates how emotionally charged decisions can have a devastating effect on long-term performance.
Even if investors have the emotional fortitude to stay the course through bear markets, there may be other reasons that compel them to liquidate stocks, whether it be to fund living expenses, help their children buy homes, or invest in other opportunities. Unfortunately, the markets pay no heed to the convenience of mortals. If you are lucky, the need for cash will materialize at market peaks. Conversely, if you need liquidity near market troughs, the effect is similar to that detailed in the graph above.
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Article content Bonds: The good news and the bad news Historically, investors have used bonds to diversify their stock portfolios and weather periodic stock market downturns. Over the past several decades, the diversification value from holding bonds has been neutral to overall portfolio returns. During the bull market in bonds of the past 30 years, bond returns have just about kept pace with those of stocks. However, as indicated by the table at the beginning of this missive, this has not typically been the case.
Bonds can also be less stable than stocks and just as vulnerable to extreme losses. Since 1900, the maximum peak-to-trough loss in real terms for long-term U.S. government bonds was 68 per cent as compared to 73 per cent for U.S. stocks. Looking at 10-year rolling periods since 1807, the worst stock performance was actually better than that of bonds.
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Article content In his 2012 annual letter to Berkshire Hathaway Inc. shareholders, Warren Buffett said: “Bonds are among the most dangerous of assets. Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as these holders continued to receive timely payments of interest and principal … Right now, bonds should come with a warning label.”
John Bogle, founder and former chairman of The Vanguard Group Inc., said that since 1926, the yield on 10-year U.S. Treasury notes explains 92 per cent of the annualized return that an investor would have earned had one held the notes to maturity and reinvested the interest payments at prevailing rates. The current yield on 10-year Treasuries of 2.78 per cent is thus a good estimate of the future returns investors can expect from holding intermediate-term Treasury bonds.
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Article content As indicated in the table below, bonds have provided significant diversification benefits in more recent bear markets.
The tendency of bonds to move inversely to stocks and provide portfolio diversification has not always been the case. Since 1973, stocks and bonds have been positively correlated more than 50 per cent of the time. The first half of this year serves as a stark reminder that bonds can fail to deliver when stocks falter, with 10-year U.S. Treasuries declining 10.5 per cent as global equities fell 20 per cent.
Threading the needle On the one hand, a permanent allocation to bonds is likely to be a significant drag on portfolio returns over the long term. Moreover, bonds are not guaranteed to move in the opposite direction of stocks during periods of equity market turmoil. On the other hand, bond holdings tend to reduce portfolio volatility over shorter time periods.
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Article content Noah Solomon: Why the Fed might not save stock markets this time Three strategies to help you take the emotion out of investing Five things — good and bad — affecting investors this summer Options are a great way to lose money, unless you’re the one selling them Stable, dividend-paying stocks offer an efficient alternative to bonds. Over long-periods of time, they have generated higher returns than their non-dividend-paying counterparts while suffering shallower losses in challenging periods. Over the past 20 years ending June 2022, the S&P 500 Dividend Aristocrats Index has produced a total return of 624.7 per cent as compared to 468.6 per cent for the S&P 500 index. Over the same period, the TSX Dividend Aristocrats Index returned 555.7 per cent versus 355 per cent for the S&P/TSX composite index.
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In addition, dividend-paying companies tend to hold up better than their non-dividend paying peers in challenging environments. During the first six months of 2022, the S&P 500 index suffered a loss of 20 per cent compared to a decline of only 12.2 per cent by the S&P 500 Dividend Aristocrats Index. Looking north of the border, the S&P/TSX composite index fell 9.9 per cent versus a decline of 5.3 per cent for the S&P/TSX Canadian Dividend Aristocrats Index.
The evidence is clear. If you like the idea of lower volatility, shallow losses in bear markets and higher long-term returns, then it would be prudent to increase your allocation to high-quality dividend-paying stocks.
Noah Solomon is chief investment officer at Outcome Metric Asset Management LP.
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