when deflation ruled and government bonds were the only appreciating
assets. As a result international investors fled to the U.S. government se-
curity market when turmoil hit equities and other currencies. Long-term
U.S. government bonds became “safe havens” for investors fearing a
meltdown in the stock market.^5
This tendency for investors to hide in long-term U.S. Treasury is-
sues when equities experienced sudden declines persisted, despite the
Asian recovery and the improving Japanese economy. As central banks
have held firm against inflation, government bonds can be an island of
stability when there is financial stress.
But it is an open question whether bonds will be good long-termdi-
versifiers, especially if the specter of inflation looms once again. Never-
theless, the premium now enjoyed by Treasury issues generated by
investors seeking short-termsafe havens means that the return on gov-
ernment bonds will be low and they will become less desirable to long-
term investors.
EFFICIENT FRONTIERS^6
Modern portfolio theory describes how investors may alter the risk
and return of a portfolio by changing the mix between assets. Figure
2-5, based on the 200-year history of stock and bond returns, displays
the risks and returns that result from varying the proportion of stocks
and bonds in a portfolio over various holding periods ranging from 1
to 30 years.
The square at the bottom of each curve represents the risk and re-
turn of an all-bond portfolio, while the cross at the top of the curve rep-
resents the risk and return of an all-stock portfolio. The circle falling
somewhere on the curve indicates the minimum risk achievable by
combining stocks and bonds. The curve that connects these points rep-
resents the risk and return of all blends of portfolios from 100 percent
bonds to 100 percent stocks. This curve, called the efficient frontier, is the
heart of modern portfolio analysis and is the foundation of asset alloca-
tion models.
Investors can achieve any combination of risk and return along the
curve by changing the proportion of stocks and bonds. Moving up the
32 PART 1 The Verdict of History
(^5) Short-term Treasury securities such as bills have often enjoyed safe-haven status. Rising bond prices
in a tumultuous equity market also occurred during the October 19, 1987, stock market crash, but
much of the rise then was predicated on the (correct) belief that the Fed would lower short-term rates.
(^6) This section, which contains some advanced material, can be skipped without loss of continuity.