This is a good question, isn’t it?
Most of us take equity mutual funds’ outperformance over debt mutual funds for granted.
Let’s see why this outperformance exists. Once this is done, we will move on to validating this outperformance.
Since equity mutual funds invest in a bunch of equities and debt mutual funds invest in a bonds or debt or fixed income instruments, we can replace equity mutual funds with ‘equity’ and debt mutual funds with ‘debt’ for the sake of this piece. If equity outperforms debt, then equity mutual funds must outperform debt mutual funds.
Why equity outperforms debt – fundamental reason
For this, we need to revisit the definition of equity and debt. Just to quickly recap:
Equity is essentially ownership of a business. Buying a company’s stocks or equity make you a part owner in the company. If the company makes money, you make money. If the company loses money, you lose money.
On the other hand, bond or debt is nothing but loan. When you buy a company’s bond, you are essentially lending money to the company. The company has a contractual obligation to pay an agreed interest rate at an agreed frequency as well as a contractual obligation to pay back the original principal after the maturity of the bond.
If a company goes bust, bond/debt owners are paid first (by liquidating the assets of the company). Once all bond owners are paid, whatever is left is distributed to the equity holders (the owners)
Now compare the risk of holding stocks vis-à-vis holding bonds.
Not only do bond investors have a contractual backing for their interest and principal payment, they have a greater right on company’s liquefied assets in an event of company going out of business.
Equity investors do not have these protections.
Bottom line – Investing in equity is inherently riskier than investing in debt. Therefore, investors would always demand higher returns when investing in equity than they would when investing in debt.
Think of it this way – If equity returns in the long term do not exceed bond returns, why would anyone invest in stocks and take that higher amount of risk?
This does not mean that ALL stocks will outperform ALL bonds in the long term. Some businesses are good while some businesses are bad. If you invest in bad businesses, you will end up with bad returns.
But, fundamentally, a well-constructed index of stocks should outperform a bond index in the long-term. Otherwise, there will be no incentive to invest in stocks or for that matter, even start a business.
Let’s see if this ‘equity > bond’ theory is validated by history.
Does equity always outperform debt?
Since Indian markets do not offer a substantial amount of history for this type of an analysis, we will turn towards US markets.
We will look at annualized returns of S&P composite index – including dividend [equity] and compare it with annualized returns of 10-year US Treasury [debt]. We will go all the way back to 1871 thereby using almost 150 years of real world data.
Our analysis will show that equity does indeed outperform debt but only in the long-term. “Long-term” becomes the keyword here.
We will start by comparing annualized returns for a 5-year holding period. The chart below gives the comparison for every year since 1871:
As we can see, the orange line (bond returns) is above the blue line (stock returns) a reasonable number of times (24.6% of times to be precise).
Therefore, if the holding period is 5 years or less, bonds have outperformed stocks with a reasonable amount of consistency.
Let’s see what happens if we increase our holding period to 10 years.
As we can see, instances of outperformance by stocks have increased.
However, there are still fairly decent number of 10-year periods (15% to be precise) where bonds outperformed stocks.
Now let’s see what happens when we increase the holding period to 20 years.
And now we are talking! There are hardly any discernible instances where bonds outperformed stocks. In terms of numbers, that’s just 2 times in last 129 such 20-year periods.
Given this insight, we can safely say that historical performance data does support the fundamental theory that in the long-term, stocks outperform bonds.
Note: All calculations are based on Online Data by Robert Shiller.
Also published on Medium.