What has been left out of this discussion of asset allocation? The main purpose of asset allocation is to diversify investment risks. Yet the menu of assets we have considered offers relatively little opportunity to diversify into low correlation assets. It’s true that stocks and bonds have a very low correlation. But within the stock and bond categories, almost every asset is highly correlated. That’s even true of foreign stocks which are relatively highly correlated with domestics stocks, especially over recent periods. Similarly, as shown in Chapter 7, most U.S. bonds are highly correlated with one another.

To truly achieve diversification, perhaps the investor has to move beyond ordinary capital market assets. That is certainly the lesson learned from the experience of the Yale University Endowment. In Chapter 13, we will review that experience in detail. At this point, let’s just point out that the Yale University Endowment portfolio bears little resemblance to the portfolios discussed in this chapter. Less than 25 percent of the portfolio is invested in traditional capital market assets, bonds and stocks. Interestingly enough, the allocation to foreign stocks is larger than that to domestic stocks (10 percent versus 7.5 percent). The rest of the portfolio is allocated to three types of alternative investments:

1. Private equity (mostly venture capital and buyout funds)

2. Absolute return (mostly hedge funds with either event-driven ...

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