Stocks vs Bonds: A Puzzle and Half a Solution

On average, buying stocks gives you a better return than buying bonds. That has been true for a long time. The return from stocks is less predictable than that from bonds, but the difference in return is large enough to make risk aversion an inadequate explanation. That, at least, is my understanding of the conclusion of those who have studied the question.

This presents an obvious puzzle to an economist. If stocks provide a better return than bonds, investors should shift to stocks. Once prices have adjusted to the shift, the future return on stocks should be lower than before, on bonds higher, and the process should continue until the returns are roughly equal, allowing for the different risks of the two kinds of investment. Yet that does not seem to have happened.

Some time ago I came up with a solution. Unfortunately, there is a serious problem with it. The purpose of this post is to explain the solution in the hope that someone else can see how to patch the hole.

I start with a simple assumption: All investors have inside information. Someone who works in a company knows a little more than outsiders about the prospects for that company. Someone who has made a career in an industry has a feel for what is happening in the industry. An enthusiastic customer in some niche market knows better than most which products are good and which firms are likely to prosper. One of the functions of the stock market is to put together all of this dispersed information and come up with stock prices.

Suppose I have expert knowledge of the industry I work in and money to invest. Investing all of it in that industry is risky, especially if I work in that industry, since I don't want the risk on my investments to correlate with risks to my income. So I invest some of it in the industry, taking advantage of my special information to do so, and the rest elsewhere. On the margin I am getting the return of an uninformed investor, on the average something between that and the return of an expert investor. Since everyone else is doing the same thing, everyone is getting that result.

What about investing in bonds? Since I have already invested as much as I want in the area of my expertise, investments in bonds substitute for the uninformed part of my investment. So, in equilibrium, the return on bonds will (ignoring any risk premiums) equal the return on my marginal investment in stock and be lower than my average return on stock--explaining why, on average, stock gives a better return than bonds.

The problem with this is that it depends on my uninformed investment giving a worse result than investing at random, since random investments ought to pay me the average return on stocks.

Anyone with a good solution? It's worth noting that the problem applies to other and more conventional views of the stock market. In order for clever investors to do better than average, someone has to do worse.