Stocks vs. Bonds Critique and How It Applies to Financial Management
The paper is a critique of an article titled “Stocks versus bonds: Explaining the equity risk premium” written by Asness, C. S. It was published back in 2000. The article suggests that financial managers are in a better position to understand and comprehend the issues dealing with the relationship between bonds and stocks. Asness, (2000) has explained how dividend and earning yields on stocks are generally higher than yields on long-term government of the United States. The writer has argued that, this difference is as a result of long-run differences in stock and bond volatility. This difference has been detailed in a manner that financial managers can understand the ever changing complex issues particularly those relating to stock verses bonds in asset class comparison. To help many understand how and why the difference between stocks and bonds over a given period exist, Asness has expounded differences by the use of data starting from 1927 to 1998 data.
In looking at the differences, the writer used equation model required by the stock yield [D/P = Y0 + Y1Y + Y2α (stock) +Y3α (bonds) + έD/P α.r]. This is equation 6 and considers three questions. The first question outlines the reasons why stock market resulted in a strong out-yield bonds for longer period of time, but later resulted to under-yields. In explaining this question, the writer linked the question with what happened before 1950, where bond yields were out-yielded by stock market due to stock vs. bond volatility, which was much higher as compared to what is happening today. This analysis has been of great challenge to financial managers due to future uncertainties. However one problem with the article is that, it does not explain the circumstances that led to out-yielding of bonds by the stock market before 1950 and under-yielding after 1950.
According to Asness, (2000), stock and bond yields used to move independently from 1927 to 1998, but before that they were moving together. In explaining this, the writer clearly relates it with the structural relationship that was missing. The article explains to financial managers that stock and bond yields can correlate positively for a very long period of time in case they take into account the effects of volatility. However, Asness, (2000) does not explain such effects and how to mitigate them.
Another issue brought out clearly by the writer is that, the current stock markets are very low as a result of low bond yields. However comparing stock market volatility and bond market volatility, Asness, (2000) found that stock market volatility is very low as compared to bond volatility. The model used by the writer explains all the factors that have led to this scenario. According to the model, there are no chances of going much lower as compared to the current rate, unless interest rates fall. However the writer has not explained different statistical means of testing both long-term as well as slowly changing relationships, thought the model past robustness checks like out-of-sample tests of untouched periods. In addition, the model does not explain extensively the link existing within asset classes. This article only explain a temporal link which the past studies failed to explain.
This work is of great help particularly to financial management, though its application is theoretical. Studies have confirmed this relationship particularly in asset class comparison that is stock vs. bonds. Financial managers form the backbone of investment and asset class comparison. As a result, they should be in a position to understand actuarial tables of expected returns and assets classes. According to Asness, 2000) financial managers need to understand the meaning of these tables and how to create them. This knowledge can be obtained from stock vs. bond relationships which have been explained in this article.
In conclusion this article extensively explains various relationships between stock and bonds. However some work need to be done to link within asset classes to determine the relationship. In addition more work should be done to devise software which will be of great help to financial managers in different computations.
Reference
Asness, C. S. (2000). Stocks versus bonds: Explaining the equity risk premium. Financial Analysts Journal, 56(2), 96 -113.