Which performed better in the past, Stocks or Bonds? The ratio in the chart above divides the S&P 500 by a Total Return Bond Index. When the ratio rises, stocks beat bonds - and when it falls, bonds beat stocks.
Stocks are a form of equity and Bonds are a form of debt. Equity and debt are the two different ways of financing a company. Stocks are riskier than bonds. They represent an ownership stake in a company and let you participate in its profits and losses. When the company goes bankrupt the shareholders get paid last. Whereas stocks pay dividends, bonds pay interest. In contrast to dividends, the interest payments on bonds are guaranteed. For this reason bonds are classified as "fixed income" instruments.
Due to its "fixed income" nature, a bond's value is primarily influenced by changes in inflation and interest rates. A stock's value on the other hand is susceptible to a variety of factors, including changes in earnings growth expectations.
This chart gives a different view of the data from the chart above, comparing the percentage change between S&P 500 and the Total Return Bond Index over time.
The Bond Index until 1972 was calculated using Edward McQuarrie's data (pages 38-40). Until 1826 the index consists of federal bonds, until 1850 it's mostly municipal bonds, and until 1897 it's an aggregate of federal, municipal and corporate bonds. Since 1897 the index is based on investment grade corporate bonds.
This version of the S&P 500 is a price return index in contrast to total return index. Therefore, it does not include dividends. Including dividends leads to a very different picture, which is demonstrated in the chart below.
The ratio in the chart above consists of total return indices for both stocks and bonds. Therefore, dividend payments from stocks are also taken into account. The methodology and the data sources for the Total Return Stock Index are described on this page.
The correlation between stocks and bonds is one of the most important inputs to the asset allocation decision.
However, it's important to understand that this correlation is not static and can change over time, primarily influenced by macroeconomic conditions and recessions. During periods of economic expansion and positive market sentiment, stocks generally perform well, resulting in a positive correlation with bonds. Conversely, during economic recessions, bonds often experience a rally due to both a flight to safety and central banks implementing interest rate cuts as a means to stimulate the economy. This leads to a situation where there is frequently a negative correlation between stocks and bonds during economic downturns.
The chart above displays the 1-year rolling correlation coefficient between the S&P 500 and and the Total Return Bond Index. A correlation coefficient of +1 indicates a perfect positive correlation, meaning that stocks and bonds moved in the same direction during the preceding time window. Conversely, a correlation coefficient of -1 indicates that stocks and bonds moved in opposite directions. In early 2022, the FED's decision to raise interest rates led to a simultaneous decline in both stocks and bonds, causing the 1-year rolling correlation to approach 1.
The correlation coefficient is important to consider for diversification because it helps investors assess the potential benefits of including both stocks and bonds in their investment portfolios. Diversification is the practice of spreading investments across different asset classes to reduce risk. In his book Principles, Ray Dalio called diversification the “Holy Grail of Investing”. He realized that with fifteen to twenty uncorrelated return streams, he could dramatically reduce the risks without reducing the expected returns.
Special thanks to Edward F. McQuarrie for generously providing data and advice that led to the creation of this page.
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