Asset Allocation

Expected Returns on Stocks and Bonds

Topics - Asset Allocation Strategic Asset Allocation Portfolio Construction

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Expected Returns on Stocks and Bonds

The equity-bond risk premium — the long-run expected return advantage of stocks over government bonds — is one of the biggest questions in financial markets. The extent of the premium is widely debated, but it is reasonably clear that it declined in the last quarter of the 20th century, to partly rebound in the first years of the 21st century.

Our review provides a road map to the complex literature on the topic. We explain the key drivers of the risk premium and varying assumptions about them, letting investors themselves assess the  long-run prospects for stocks versus bonds. Long-term government bond yields are known, while prospective equity returns are inherently less transparent and thus more open to question.

There is an ongoing shift in opinion about expected returns. Long-term equity premiums have traditionally been predicted from historical average asset performance assuming a constant risk premium, but today they are increasingly predicted with the help of dividend discount models, assuming time-varying expected returns.

We first review the historical average returns of major asset classes and explain why we believe these are misleading guides for the future. Essentially, the double-digit returns of the 20th century were due to equities starting cheap and getting richer over time. Many investors extrapolated this past performance and expected (at least) as high future returns. Investors thus missed, first, the fact that a part of realized returns was unexpected windfalls from rising equity valuation multiples, and, second, that when starting from high valuation levels it is not reasonable to expect as high returns as in the past.

Published in

The Journal of Portfolio Management

This document is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein.

This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC (“AQR”) to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. This document is not to be reproduced or redistributed to any other person. The information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation decision. Past performance is not a guarantee of future performance. 

This material is not research and should not be treated as research. This paper does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR. The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein. 

The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor the author guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such. Diversification does not eliminate the risk of experiencing investment losses.

The information in this paper may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.