stocks outperform bonds

Bonds vs Stocks: which is better

The story goes that the average stock market return is 5-7%. But bonds vs stocks, which is better? Investors say that stocks outperform bonds, but is this still true? I’d suggest we delve in a bit of historical data to find out.

First, let’s set some parameters. I think that the last 5 years are as good of a period as any other. There is a lot more retail activity as stocks are easily accessible from most phones and we also benefit from ample liquidity.

Overall, it’s a great time to invest. I will examine the UK and US markets but Gold and Japanese equities are also in the mix for diversification purposes. Here is a list of the exchange traded funds (ETFs) used: CUKX (UK stocks), VGOV (UK bonds), XGLS (gold), SPXP (US stocks), CBU0 (US bonds) and IJPH (Japan stocks).

Bonds vs Stocks: UK market

We’ll start with the performance of the FTSE100 index, the 100 biggest companies in the UK.

bonds vs stocks

That’s a bit underwhelming: -7.86%. But don’t worry these companies pay dividends too so next we shall look at the ETFs.

All of these are available to retail, denominated in GBP and the equity ones reinvest the dividends for you. Sadly, I couldn’t find a UK bond ETF which re-invests dividends and was around in 2015 so we’ll have to settle for a dividend pay out.

I feel a bit better now that the FTSE 100 is actually up 15.64% with the dividends reinvested. However, bonds outperformed it significantly at 21.69% and that’s without the dividends. To be fair Gold completely blew both of these out of the water at 46.81%.

Someone may argue that stocks have not been cured from the coronavirus yet, so let’s hop across the pond and check out what is going on in the US of A.

Bonds vs Stocks: US market

Wow, 116.98%, I’m speechless, now we’re talking, well done S&P 500 (the 500 biggest US companies)! Gold gets a distant second place and I’m not sure if I should even be talking about bonds at 27.36%. Again, these are all GBP denominated ETFs.

Overall result

I think that the chart is pretty self explanatory, The S&P 500 is the winner, hands down, then Gold gets the 2nd place. Everything else is in the 15-30% range with Japanese equities at 20%. The average returns per year are:

S&P 50023.40%
US bonds5.47%
UK bonds4.34%
Japan equities3.91%
FTSE 1003.12%

Is inflation going to obliterate these returns?

Effect of inflation on returns

I don’t like to use inflation for discounting. It just isn’t representative of the cost of living. This is why some suggest the Consumer price index (CPI) but I don’t like that either.

At the end of the day most of us are involved in the housing market via renting or a mortgage and we all pay council tax. Because of this I settled for the Retail price index (RPI) which is only available until 2019, so I used 3/4 of the 2019 value for 2020.

Here is an example of what the depreciation of the purchasing power of £1000 would look like from 2015 to present:

Starting amount at the beginning of 2015: £    1,000.00
Value at the end of the year*990.00973.17938.14907.18883.59866.36
* The value for 2020 is discounted until the end of September only, not for a full year

RPI adjusted return

* Diversified refers to a portfolio which consists of 16.67% of each of the instruments compared in the table

The RPI adjustment pretty much annihilated any return other than the S&P 500 and gold. I was slightly surprised that I ended up with a 4.55% average annual return.

I have to agree that the 5-7% average annual return range holds for a mixture of the UK, USA, Japan & Gold. Usually 5% is quoted for inflation adjusted return, which is exactly what I did by discounting for the RPI.

Nevertheless, the UK market return is really poor, a 50/50 bonds and equity portfolio would have returned a mediocre 0.655% per year. I don’t think I’m building a case for long term investing so please bear with me, it will all make sense in the next section.

What happens if we use a tax shield

A private pension uses a tax shield. This means that you don’t get taxed on the contributions. For example, if I was to put £1000 in my ISA, I could have put £1428.57 in a SIPP assuming I pay around 30% tax. The gain from the tax shield in this example is £428.57 or 42.86%!

However, the downside is that I am giving away the opportunity to make withdraws whenever I feel like it. Even worse, I’d have to wait for a very long time to access my money.

Now I am going to take the money, discount them for the RPI and then I will calculate the return based on the opportunity cost (which is £1000).

The reason is that any other stock market investment (ISA for example) would be made with taxed money so this reflects the overall economic benefit of using the tax shield.

Just bear in mind that the table below does not include fees, you’d need to knock out 1-2% to account for them.

* Diversified refers to a portfolio which consists of 16.67% of each of the instruments compared in the table

That’s more like it! Now it makes a lot of sense to invest and while the S&P 500 is still the best performing, the rest of the elements are not dragging down the return too much.

I suppose someone may ask why shouldn’t we just put all our money in the S&P 500. Firstly, we’ll increase the overall volatility. Secondly, we simply don’t know if it will perform that well in the future. It could be the FTSE 100’s turn next time.

Bonds vs Stocks Conclusion

There are different ways to invest and all of us have different circumstances. In this study UK bonds outperformed UK stocks for the period examined.

This wasn’t the case in the US market. I hope that the examples illustrated that returns can vary significantly not just by choice of market but also due to tax efficiency.

If you are unsure what’s best for you or you struggle to understand the article you can always seek the help of a professional. You may not be ready to be a self-directed investor. There are plenty of talented people out there who’d be happy to help you out.