Social Security and Market Risk

Studies | Social Security

No. 244
Tuesday, July 31, 2001
by Liqun Liu, Andrew J. Rettenmaier, and Zijun Wang


Stock and Bond Returns, 1872-2000

Figure I - Accumulated Value of a %241 Investment in 1872

"Stocks outperform bonds and any mixed portfolio over 128 years."

Figure I shows how a single dollar invested in 1872 would grow, with the interest and dividends reinvested, if held until 2000.2 It shows the performance of an investment consisting entirely of stocks in the Standard & Poor's 500 and three mixed portfolios of S&P stocks and corporate bonds rated AAA by Moody.3 As summarized in Table I, over the entire 128-year period:

  • A $1 investment in a portfolio comprised entirely of stocks would grow to $6,410.
  • Invested in a portfolio comprised of 75 percent stocks and 25 percent bonds, the $1 would grow to $2,706.
  • A 60 percent stock and 40 percent bond portfolio would grow to $1,484.
  • A portfolio weighted with 75 percent bonds would grow to $289.

Clearly, stocks far outperform bonds and any mixed portfolio of stocks and bonds over the 128-year period. Does this relationship work for shorter periods of time?

"The return on stocks varies from a worst-year drop of 35 percent to a best-year increase of 47 percent."

Return on a Stock Portfolio. Figure II compares year-by-year rates of return on stocks and rates of return over periods of 35 years. The lighter, jagged line shows the rate of return each year. The heavier line shows the internal rate of return over the previous 35 years. We assume an annual contribution of $1, since Social Security tax payments are also made annually rather than in one lump sum.

Table I - Annual Real Rates of Return and Consequences of Investing %241 from 1872 to 2000

The annual fluctuations in stock returns between 1906 and 2000 range from a worst-year drop of 35 percent to a best-year increase of 47 percent. These wide year-to-year fluctuations fuel the concerns of those who oppose allowing workers to invest part of their Social Security tax payments in the stock market. However, as the figure also shows, a longer holding period dramatically reduces the variation in rates of return.4 Although the market is volatile on a daily or annual basis, the volatility is dramatically reduced - often to a few percentage points - over long holding periods.

  • The worst 35-year period, which ended in 1921, produced an average real rate of return of 2.7 percent.
  • The best period, ending in 1965, produced an average real rate of return of 9.5 percent.
  • Thus the difference between the best and worst results is less than 6 percentage points.

"But over 35-year periods, the difference between the best and worst returns from stocks is less than 6 percentage points."

Return on a Bond Portfolio. The annual fluctuations in a 100 percent bond portfolio are less dramatic than those of stocks, but returns still range from a one-year low of -10.8 percent to a one-year high of 18.4 percent. As was the case with the stock portfolio, the rates of return over 35-year periods are much more stable, as Figure III shows.

Figure II - Return on Stocks
  • The worst average real return from a 35-year bond portfolio investment was 0.6 percent for the period ending in 1920.
  • The best return, for the period ending in 1906, was 5.1 percent.
  • The difference between the best and worst return is less than 5 percentage points.

"Although there is a common perception that stocks are more risky, they outperformed bonds in every period of 20 years or more."

Return on a Mixed Portfolio. A portfolio of 60 percent stocks and 40 percent bonds is often viewed as representing the underlying mix of corporate financing instruments across all firms. Figure IV shows the yearly return and average return over the series of 35-year periods for such a portfolio, rebalanced each year to maintain the same proportion of stocks and bonds.5 Between 1906 and 2000, the annual returns ranged from a one-year low of -16.8 percent to a one-year high of 29 percent. By contrast, for 35-year periods:

  • The lowest real average return, for the period ending in 1920, was 2.0 percent.
  • The highest average return was 7.3 percent for the period ending in 2000.
  • The average for all 35-year periods was 5.1 percent.

"Although there is a common perception that stocks are more risky, they outperformed bonds in every period of 20 years or more."

Comparison of Portfolios. Another way to evaluate the relative performance of stocks and bonds is to calculate how often a portfolio comprised exclusively of stocks outperforms a 100 percent bond portfolio. Economist Jeremy Siegel points out that for the period 1871 to 1996, stocks outperformed bonds 59.5 percent of the time over a one-year holding period, but when the holding period was 10 years, stocks outperformed bonds 82.1 percent of the time, and when the holding period was 30 years, stocks always outperformed bonds.6

Figure III - Return on Bonds

Table II summarizes the internal rates of return distributions for portfolios, with varying mixes of stocks and bonds, held for varying lengths of time during the 1872 to 2000 era. As the table shows, when the holding period lengthens, average returns decline, but so does the volatility of the portfolio.7 The table also shows how the average minimum return rises along with an increase in the share of stocks in the portfolio when the holding period is 20 or more years.

  • Although there is a common perception that stocks are more risky than bonds, stocks outperformed bonds in every one of the 95 periods.
  • In addition, all-stock portfolios almost always outperformed mixed portfolios containing both stocks and bonds.

"Bond portfolios and mixed portfolios are also more stable over long periods of time."

Furthermore, the performance of the capital markets is much better than what the young today can expect on their Social Security payroll tax dollars.

  • The average annual real rate of return for an all-stock portfolio was 6.4 percent over the 95 periods, with the lowest being 2.7 percent for the period ending in 1921.
  • A portfolio of 60 percent stocks and 40 percent bonds produced an average annual real rate of return of 5.1 percent, with the lowest being 2.0 percent for the period ending in 1920.
  • By contrast, virtually all young people entering the labor market can expect a rate of return on their Social Security taxes of less than 2 percent.
Figure IV - Return On a 60% Stock 40% Bond Portfolio

Table II - Summary of Internal Rates of Return


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