This is of course relevant to the current debate over privatization of social security. Below I've reproduced a figure from William Bernstein's site Efficient Frontier, which shows the probability of equity outperformance for a given value of the risk premium and an assumed historical volatility of about 17% for stocks. For example, if the risk premium is only 2% over the next 20 years, there is a 35% chance the equity portion of an individual account will actually do worse than if it were invested in treasuries.
Bernstein attributes the very different results of the 19th and 20th centuries to inflation. He claims that in the 19th century inflation was not understood to be a threat to bond returns. At the beginning of the 20th century, bond yields were 5%, which looked pretty attractive, as it was assumed to be a real rather than nominal yield. The inflation brought on by two world wars and the death of the gold standard was disastrous for bond holders. On the other hand, equity returns managed to keep pace with inflation (companies could pass increased costs on to consumers). As a consequence, investors bid up equities and devalued bonds. I still think there are obvious reasons (such as short-term volatility) for investors to demand a premium for holding equities. But a 5% equity premium is quite optimistic.
Bernstein: With hindsight we can see that the 5% stock-bond return gap in the 20th century was the result of a totally unexpected inflationary burst produced by the abandonment of hard money. You can’t abandon hard money twice, so a repeat is not possible. Though inflation might increase dramatically in the future, resulting in another high stock-bond return gap, it’s at least as likely that inflation will remain tame for the foreseeable future, producing nearly equal stock and bond returns. More importantly, we now live in a world where investors have learned to extract an inflation premium from bonds and to expect inflation protection from stocks.
