• Traditionally, stocks have been used for growth and bonds for safety
  • Therefore, investors looking for long-term capital appreciation tended to allocate heavily towards stocks while investors concerned about preservation allocate more heavily towards bonds
  • With an anemic forecast for equity returns over the next decade, could the best place to find growth actually be with income?

It is common practice in the investment industry to allocate investors with a longer horizon more heavily towards equities and allocate those investors with shorter horizons more heavily towards bonds.  Adjusting these relative weights over an investor’s lifecycle helps keep their risk tolerance inline.  When investors are young, their biggest risk is typically failing to grow their portfolio sufficiently.  When investors are approaching retirement, or in retirement, their biggest risk is losing significant capital.

Whether sophisticated planning tools are used or simple ad hoc rules like “one-hundred minus your age,” the general framework remains the same: stocks are for growth and bonds are for safety.

The way investors generally perceive risk aligns with this framework.  One academic study showed that investors tended to consider stocks riskier when they measured risk as uncertainty, but bonds riskier than stocks if they measured risk based on terminal wealth.

The evidence discussed here, based on a comprehensive sample of 19 countries over 110 years, suggests that investors that focus on uncertainty are likely to view stocks as riskier than bonds, and those that focus on long-term terminal wealth are likely to view stocks as less risky than bonds even if they are concerned with tail risks.  This is the case because, even when tail risks do materialize, investors are more likely to have a higher terminal wealth (that is, more capital at the end of the holding period) by investing in stocks than investing in bonds.”

Estrada, Javier, Rethinking Risk (August 30, 2013). Available at SSRN:


While we’ve always been big proponents of simple frameworks, we think there is a large flaw in this line of thinking: it’s based, largely, on “long-term” averages.

And by “long-term,” we mean much, much, much longer than the usual 20-40 year horizon most investors have.

This is only made worse for U.S. investors whose experience with equities has been a considerable outlier in comparison to other global equity markets.  In their paper Global Stock market in the Twentieth Century, Philippe Jorion and William Goetzmann argue that long-term stock estimates derived from U.S. equity markets are highly suspect due to survivorship bias.  In other words, the estimates fail to account for how other equity markets around the globe have done.

Spoiler alert: U.S. markets have trounced everyone else.  From 1921 to 1996, U.S. equities had the highest annualized real return at 4.3% versus a median of 0.8% for all other countries examined in the study.

Country Returns

So when we use the simple “stocks for growth, bonds for safety” heuristic, we’re invoking a rule based on shaky statistics.

A better method may be to actually update our forecasts for expected returns instead of using some unrealistic long-term number like 8%.

John Bogle, godfather of passive investing, recently gave an interview with Morningstar where he discussed his outlook for U.S. equities.  And the outlook is grim.

John uses a very simple framework to estimate forward long-term returns.  First we start with the dividend yield.  Then we add on our expected earnings growth.  Finally, we add on any “speculative return” that might be due to re-pricing back to long-term means.  For example, if the S&P 500 is above its long-term P/E average, we might expect a negative speculative return as the market “re-prices” back to a normal P/E level.

Bogle believes we’ll see a dividend yield of 2%, earnings growth of 5%, and a speculative return of -3%.  This puts the long-term nominal expected return at 4%.  Once you factor in inflation of 2%, we end up with an expected real return of a meager 2%.

Bogle Return Breakdown

Research Affiliates actually publishes their forward expected returns online and uses a similar framework.  As of 9/30/2015, the forward expected real return for large cap U.S. stocks is a mere 1.1% (yield of 2.0%, growth of 1.3% and a valuation of -2.1%).

Whether it is 1.1% or 2%, the takeaway is obvious: it will be a tremendous surprise if stocks return anywhere close to their long-term historical averages over the next decade.

At Newfound, we typically simplify this formula as “total return equals income plus capital appreciation.”  For equities, it is the capital appreciation side that looks shaky over the next decade.  So how might we be able to offset this?

With more income, of course.

We don’t just mean a larger portfolio allocation to core bonds, though.  We mean finding asset classes that offer high income opportunities.

For example, on the same Research Affiliates site, we can see their forecasts for several high income categories:

CategoryExpected Return
High Yield2.8%
Bank Loans2.2%
EM Debt (Non-Local)2.6%
EM Debt (Local)5.0%

We can see that all of these high income asset classes have at least double the expected return Research Affiliates predicts for large-cap U.S. equities.

Under the hood of these predictions we can see just how important the yield component is.  REITs actually have negative earnings growth expectations – but the yield is large enough to offset it from a total return standpoint.

As the end of the year approaches and investors look to re-position their portfolios looking towards the next decade, the old heuristics of “stocks for growth, bonds for safety” may lead them astray.

Ironically, it may be income that ends up being the largest portfolio driver of growth over the next decade.

Corey is co-founder and Chief Investment Officer of Newfound Research, a quantitative asset manager offering a suite of separately managed accounts and mutual funds. At Newfound, Corey is responsible for portfolio management, investment research, strategy development, and communication of the firm's views to clients. Prior to offering asset management services, Newfound licensed research from the quantitative investment models developed by Corey. At peak, this research helped steer the tactical allocation decisions for upwards of $10bn. Corey holds a Master of Science in Computational Finance from Carnegie Mellon University and a Bachelor of Science in Computer Science, cum laude, from Cornell University. You can connect with Corey on LinkedIn or Twitter.