Why Do Stocks Beat Bonds?

Cullen Roche, one of my favorite financial bloggers has a post up about one of my favorite topics: Why do certain asset classes perform the way they do?

One of the lessons gleaned from long-term studies is that stocks have historically outperformed bonds. Not necessarily over the course of a year, or even a decade. But over the long run, stocks have beaten bonds.

Why is this? The answer is simple. If a lender agrees to lend his money to someone at, say, 5%, then they probably have a strong belief that the borrower can return better than 5% with it. Not only that, but the borrower believes that as well. In the aggregate, it makes sense that both parties will be right. It’s win-win. While it’s true that the lender would be fine with the money not coming from future cash flow, they’d probably feel a lot better that it does.

This comes back to my point about the differencw between equity and assets. An asset is just a thing like gold or copper or even a house. But equity is a working business that takes assets to make a product. Copper is just a rock (ok, ok, an element). It just sits there. In 1,000 years, it’s still the same thing. Only when people come along can copper be employed to do something useful.

A bond is an asset as well. Remember that a stock can buy a bond, but a bond can’t buy a stock. You can form a company that does nothing but buy bonds, and then float stock to fund your operations. You can use the dividends from the bonds to buy even more bonds. In fact, you can take it one step further and borrow money to buy more bonds. Of course, you’d want to borrow at the lowest possible rate (in the short term) and invest at the highest possible rate (the long term).

Another name for this bond-business is called a bank.

My point is that equity is completely different from other classes of investments. It’s the only one that captures human ingenuity, which is the ultimate asset.

Posted by on March 10th, 2016 at 11:24 am


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