The Changing Nature of Stock and Bond Volatility

This article examines the changing nature of U.S. stock and bond risk from 1871 through 2000 and the implications for asset allocation. Using geometric means and standard deviations, we examine nominal and inflation-adjusted monthly returns over nonoverlapping 5-year periods, as well as annual returns over periods of approximately 25 years, and we document how stock and bond volatility changed over the period. Our analysis suggests that the relative change in the volatility of stocks and volatility of bonds over the past 50 years has increased the importance of stocks in asset allocation. The change is even more pronounced when inflation is considered. This article examines the changing nature of stock and bond risk from 1871 through 2000 and the implications for asset allocation. Using geometric means and standard deviations, we examine nominal and inflation-adjusted monthly returns over five-year periods, as well as annual returns over periods of approximately 25 years, and document how stock and bond volatility changed over the sample period. Our analysis suggests that the change in the relative volatility of stocks and bonds over the past 50 years has increased the attractiveness of stocks in asset allocation, and the change is even more pronounced when inflation is considered.Since about 1940, stock volatility has fluctuated in a narrow range, and both low and high mean stock returns have been associated with similar levels of volatility. But bond volatility increased during the last 35 years of the series. The best 5-year nominal mean returns on bonds occurred during a 10-year period when bond volatility was at its highest level in history.The geometric mean nominal returns of stocks exceeded those of bonds in 18 of the 26 nonoverlapping five-year periods. Inflation-adjusted geometric mean stock returns were negative in only 3 of the 26 periods, but for bonds, they were negative in 10 of the 26 periods. The inflation-adjusted geometric standard deviation of bonds was 30 percent higher than the nominal standard geometric deviation for the 1871–2000 period. For stocks in this period, however, there was little difference between inflation-adjusted and nominal geometric standard deviations.The relative riskiness of stocks and bonds has undergone a long-term change. Until roughly 1950, the ratio of the two variances (stocks to bonds) was much greater than it has been subsequently except for a single five-year period. An examination of five-year standard deviations indicates that bond risk has increased since the 1960s whereas stock risk has remained relatively steady.The correlation between bond returns and stock returns, although fluctuating, has been increasing. Combined with the increase in bond volatility relative to stock volatility, this rising correlation has important implications for asset allocation. Our analysis of the nominal risk–return trade-off available to investors shows that the situation changed after World War II. For the later two 25-year periods examined here, a 100 percent bond portfolio, or a portfolio invested primarily in bonds, compared unfavorably on a return–risk basis with several portfolios that had larger stock allocations. This outcome was most pronounced in the last period, 1974–2000, when a 70/30 stock/bond allocation had less risk and a much larger return than did a 100 percent bond portfolio. Clearly, during the last half of the 20th century, the changes in relative stock and bond volatility increased the attractiveness of stocks relative to bonds.On an inflation-adjusted basis, the case for portfolios heavily invested in bonds is even weaker than it is on a nominal basis. Bonds are affected more severely when adjusted for the increased risk caused by the covariance of nominal bond returns and inflation.