Bonds versus Stocks: Some Lessons from Capital Market Theory

The apparent end of the bear market in bonds and relatively high interest rates have led some investors to conclude that bonds are now the superior investment medium. On the other hand, stocks continue to command a large following. Theoretically, neither should completely dominate the other: some combinations of bonds and stocks should prove superior to either taken alone. We shall first summarize the theoretical argument, and then examine some relevant data. In the last decade increasing use has been made in both academic and investment institutions of the "capital asset pricing model" of Sharpe [6], Lintner [2] and Mossin [4], developed from the portfolio selection model of Markowitz [3]. The theory is described in detail in Sharpe [81 and more concisely in Vasicek and McQuown [9]. Only the major implications will be summarized here. The approach is based on a portfolio view. The investor is assumed to be concerned only with the prospects for his overall portfolio. Securities are evaluated in this context. A key aspect of the theory is the treatment of risk. Only the risk of the overall portfolio is considered important. As a corollary, the appropriate measure of an individual security's risk is its contribution to portfolio risk. When evaluating alternative portfolios, investors are assumed to prefer those with the greatest expected return for given risk. The appropriate amount of risk and return will, of course, depend on an investor's personal circumstances. But a high-risk portfolio will not be considered unless it offers a high expected return as well. The formal theory measures risk by the standard deviation of portfolio return,' but under plausible assumptions, this can be shown to be closely related to more familiar measures of risk. These considerations lead to a view of the future such as that shown in Figure I. Each point in the shaded region represents a portfolio of risky securities. Were only these alternatives available, the investor would select one of those along the upper left-hand border, depending on his tastes, circumstances, etc. However, other possibilities exist. Point P represents the (riskless) interest rate. By splitting his funds between the combination of risky securities plotted at point M and a security giving this interest rate, prospects along line PM can be attained. By borrowing funds to purchase combination M on margin at this rate, prospects along the segment MN can be attained. The preferred strategy is to select combination M of risky securities, with riskless investment or personal leverage used as required to obtain the most desirable risk-return combination along line PMN. Figure I plots prospects. Different investors will view prospects differently and thus arrive at different conclusions regarding the composition of portfolio M. Some will choose to hold a disproportionately large amount of a given security, while William F. Sharpe is Professor of Business, Stanford University, and Advisor, Computer Applications Department, Merrill Lynch, Pierce, Fenner and Smith, Inc. Comments and suggestions of Paul Cootner, Alan Kraus, Robert Litzenberger and James Van Horne of Stanford University and Guy Cooper, Gilbert Hammer and Lawrence Tint of Merrill Lynch are gratefully acknowledged. 1. Footnotes and references appear at end of article.