Question

Explain within the context of historical returns in the U.S. financial markets: Short-term stocks outperform long-term bonds.

Answer 1

1. Stocks always bear greater risk. If the company fails, stockholders get least preference. Hence stock prices incorporate this risk premium.
2. Bonds, and in particular long term bonds, have lesser price compared to stocks because of the concept of time value of money. Money after a long time in future is to be discounted to get present value. Bond prices are arrived at, by discounting future cashflows in the form of coupons and final par value. More risky the macro economic conditions are, higher will be inflation, spreads on bonds, and higher the discount rate. All of these result in lower bond prices.
3. Longer the time period to maturity of the bond, longer wil be the application of discount rates. Hence lesser will be the bond price.
4. More volatile a product is, higher is its risk and higher its price. Stock prices are more volatile, valuation of a stock depend on uncertain cashflows like the firms' future earnings and free cash flows, future growth rates etc. Bond prices are less volatile because coupons are known, final par value is known. This is also one factor why bond prices are lesser than that of stocks.