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Asset allocation for_real-world_investors_affluent_version

  1. 1. Asset Allocation for Real-World InvestorsFebruary 2010 In this special reportPrepared by 1 Combining modern portfolio theory and behavioral financeRonald Florance, CFA ® 2 Behavioral financeDirector of Investment Strategy& Asset Allocation 3 A case study of Julie and Josh SmithAnne Symanovich 3 What is the money for?Senior Investment Research 4 Basic needs strategy portfolioAnalyst 5 Lifestyle strategy portfolio 5 Philanthropy strategy portfolio 6 Legacy strategy portfolio 6 The total-net-worth portfolio
  2. 2. Asset Allocation for Real-World InvestorsAs an individual investor you likely expect your Typically, investment professionals determine anportfolio to meet a variety of needs or goals. When an investor’s level of risk tolerance and then select theinvestment professional determines what an investor’s corresponding combination of asset classes on thestrategy should be, a common practice is to identify a efficient frontier. Following this traditional approach, level of risk tolerance—a measure of the investor’s ability the portfolio at that point on the efficient frontier wouldto handle declines in his/her portfolio. This practice is be that investor’s portfolio.based on modern portfolio theory and assumes that an Modern portfolio theory was a very powerful concept wheninvestor has one, and only one, level of risk tolerance. it was first developed in the 1950s and 1960s. InstitutionalHowever, in reviewing your portfolio, you may realize investors were the first to embrace the methodology. Itthat you do not have just one investment goal or level revolutionized the way that such investors developedof risk tolerance—you have many, relating to both your investment strategies for large portfolios. Pensions,short- and longer-term needs and goals. One of the endowments, and foundations used modern portfoliogoals of behavioral finance is to address that issue. theory to allocate assets across stocks, bonds, and Your portfolio ought to be designed to satisfy an entire cash in a way that extracted the maximum potentiallife cycle of needs. The basic needs of food, clothing, and investment return with the least amount of volatility— shelter come first. Beyond that, you may want to consider or risk. As a result, portfolio strategy was no longer onlyyour lifestyle, education, retirement, philanthropic, and about General Electric vs. General Motors, but aboutlegacy goals. You should set aside specific money for General Motors bonds vs. General Motors stock as well.each goal and invest each pool of money based upon We believe that approach continues to be suited toyour unique risk, return, liquidity, cash flow, and tax institutional money management. Portfolios forrequirements for that goal. So when someone asks what pensions, endowments, and foundations have a definedyour risk tolerance is, the answer ought to be, “That investment goal. These institutions generally have a setdepends on which pool of assets you are asking about.” amount of assets (the portfolio size) and a well-definedThis special report addresses how you and your liability (pension benefit payouts or set annual payouts).investment professional can use a behavioral finance They do not pay taxes and, being large, are able to tradeapproach to develop a comprehensive investment at low transaction costs. Given this asset/liabilitystrategy to suit your individual financial needs and optimization model, creating optimal portfolios basedobjectives. When applying this approach, you begin upon risk and return works well. The level of risk isby determining the life span needs, or goals, that your commonly set by determining the level of risk needed toportfolio must address and then allocate specific assets hit the minimum return requirement to satisfy theto satisfy each of those needs. asset/liability obligation. However, we believe that the single-portfolio concept Combining modern portfolio theory is less suited to individual investors. An individualand behavioral finance investor does not have just one investment goal. Asset allocation is the process of combining different The complex life of the typical individual investorasset classes—such as stocks, bonds, and real estate— necessitates multiple investment goals. Traditional within a single portfolio with the intent of optimizing asset allocation optimization techniques are based the risk/return relationship. According to modern upon optimizing a single risk/return relationship basedportfolio theory, for every level of risk there is one upon a set asset/liability obligation. However, you may“optimal” portfolio—one that maximizes the potential find that you require the optimization of multiplereturn for a given level of risk. Using different relationships. As an investor, you may have multiplecombinations of diverse asset classes, an investment goals, and different levels of risk tolerance and returnprofessional can create an efficient frontier—a series of requirements for different pools of wealth. Behavioraloptimal, return-maximizing portfolios representing finance can help develop an effective investmentdifferent degrees of risk. strategy within a multiple-investment-goal environment. February 2010 | Asset Allocation for Real-World Investors 1
  3. 3. Behavioral finance mean-variance analysis can be combined in a way thatBehavioral finance bridges the gap between modern satisfies both the academic integrity of your investmentportfolio theory optimization and real-world investors. strategy and your emotional needs.By understanding that you may have more than oneinvestment goal and that risk and return are not the Our Starting Point: What is the Money for?only parameters about which you are concerned, yourinvestment professional can develop an investment Legacystrategy that is more suitable for your complex needs.Behavioral finance looks at the multi-dimensionalinvestment goals of investors. By articulating and Philanthropyquantifying the various obligations on an investmentportfolio, identifying appropriate risk/return Lifestylerequirements, looking beyond risk/return to otherinvestment parameters, and developing appropriateinvestor expectations, the science of behavioral finance Basic Needscan help develop a more personalized investmentstrategy that has a greater probability of meeting yourspecific needs. This diagram highlights the major requirements orSo what types of factors does this approach consider? needs that you likely expect your portfolio to support.As in the case of many theories, modern portfolio theory Typically investors have four broad categories of needs:makes assumptions about human behavior that do not 1. Basic needs. Meeting your food, shelter, andnecessarily hold true in real life. For example, it assumes immediate lifestyle necessitiesthat the pain that you feel if a stock or asset class fallsby a certain amount is equivalent to the joy you may 2. Lifestyle. Maintaining a satisfactory lifestyleexperience if the stock or asset class rises by a similar throughout your lifeamount. We do not believe that this is a true reflection 3. Philanthropy. Supporting specific causes or charitiesof human nature. In our view, the loss of a dollar 4. Legacy. Making significant bequests during or aftergenerally creates more pain than the joy created from your lifetimemaking a dollar. Within these categories, there are five sets of beneficiariesEconomic and financial theories also assume that investors that you may need to consider:tend to act rationally when it comes to investments. 1. YourselfHowever, many studies show that investors tend to pile 2. Spouse/partnerinto hot asset classes and investments just as they areready to fall. These investment decisions are based on 3. Children/heirsherd-mentality emotion, as opposed to sound invest- 4. Societyment and valuation analysis. Investors may intuitively 5. Governmentknow that the asset is overvalued, but the fear of missing out on the potential returns overpowers the There are five parameters that will need to be optimizedacademic valuation argument. Sometimes it is easier to in your portfolio:lose money with the masses than to stand alone in profit. 1. Return. Your need for a particular level of returnThese are the types of behaviors that can result in 2. Risk. The potential fluctuations in the value of yourinappropriate investment strategies for certain investments, which could result in lossesinvestors. A portfolio may appear to be invested 3. Liquidity. The degree to which you need yourprudently from a statistical point of view, but it may portfolio assets to be easily convertible to cashnot capture the multiple risk tolerance levels that 4. Cash flow. Your need for reliable cash flowsmany investors may have. Valuations of investments from your portfoliomay lead to a strategy that does not satisfy the true 5. Tax efficiency. Your need to reduce the impact ofnature of individual investors. We believe that taxes on your after-tax portfolio returnsbehavioral finance, modern portfolio theory, and2 February 2010 | Asset Allocation for Real-World Investors
  4. 4. You should consider all the requirements listed above in This couple will need the help of a wealth-planningconsultation with your investment professional. In strategist to ensure that the estate plan and investmentaddition, you ought to prioritize between needs and structure maximize the benefits of existing laws.wants to build your portfolio in such a way that Financial-planning techniques are very complex, in maximizes the probability of achieving success. light of today’s ever-changing legislative environment.This approach clearly goes well beyond traditional A wealth-planning strategist’s role would be critical inmodern portfolio theory risk/return optimization; it developing the legal structure to help the Smiths ensurerequires a better understanding of what you want your a smooth transition of assets as their lives to achieve for you. This is where behavioral Although financial-planning topics are beyond thefinance is required. scope of this special report, we’d like to stress that using wealth-planning strategists is vital for the developmentA behavioral finance approach to asset allocation of a successful investment strategy.involves three stages. In the first stage, you apportionyour assets across the four need categories listed on Now that the Smiths have decided upon their basicpage 2. In the second, you allocate the assets within investment goals, their investment professional can each of these categories, or strategy portfolios, to use the approach outlined above to start dividing themaximize the probability of achieving your desired assets amongst the four life-span needs categories orfinancial goals. In the final stage, you consolidate the strategy portfolios.four strategy portfolios to confirm that the holistic As a rule, the Smiths would be advised to set aside fourportfolio is appropriate for your family’s total wealth times their annual living expenses to meet their basicsituation. The following example illustrates how this needs. In their case, that would be $200,000. The four- approach works in practice. year cushion allows for a comfortable margin of error if there is an economic disruption. The Smiths typicallyA case study of Julie and Josh Smith would replenish their basic needs strategy portfolio withJulie and Josh Smith have worked hard, raised three assets from the lifestyle strategy portfolio. Setting asidechildren, and accumulated substantial wealth. They are enough assets to cover four years of living expenses isin their late 50s, enjoy very good health, and are in a likely to allow the Smiths to rebalance the lifestylelife transition. They no longer plan on accumulating strategy portfolio without being forced to liquidate itssignificant assets but would like their investment assets during unfavorable market conditions.portfolio to support the various financial goals that theyhave at this stage in their lives. All their children are The Smiths indicated that they would like to leave amarried and doing well. Each has one child, with more legacy of $100,000 to support their grandchildren’scoming being a real possibility. The Smiths’ portfolio college education.totals $1 million, with $150,000 in residential equity. They also want to set aside $50,000 for charity, so that is what they should allocate to the philanthropyWhat is the money for? strategy portfolio.Julie and Josh Smith live a reasonable lifestyle, given their level of wealth. They spend, on average, This leaves $650,000 to the lifestyle strategy portfolio$50,000 a year—a figure that will rise with inflation. ($500,000 in investable assets and $150,000 inThey are comfortable with their level of spending and residential equity), which, if invested appropriately, do not anticipate any significant changes. They would will likely be adequate to replace the $50,000 that thelike to set aside $50,000 to generate income so they Smiths consume every year from their basic needscan make regular donations to charities with which strategy portfolio.they are involved. The Smiths also would like tocontribute $100,000 to a series of college funds fortheir grandchildren. February 2010 | Asset Allocation for Real-World Investors 3
  5. 5. In summary, the asset allocation across the life-span Basic needs strategy portfoliostrategy portfolios is: The basic needs strategy portfolio is designed to potentially offer very low volatility, with adequateLife Span Asset Allocation liquidity and cash flow to cover the Smiths’ day-to-dayPhilanthropy $50,000 living expenses. The lowest volatility portfolio is not one that is invested 100 percent in fixed income securities, Basic Needs $200,000 but one with a small allocation to equities and complementary strategies. The asset allocation below is most likely to provide the risk control, liquidity, and Legacy $100,000Lifestyle $650,000 cash flow necessary to meet the Smiths’ basic needs: Basic Needs Strategy Portfolio Complementary Strategies 6% Commodities 2%Now we need to allocate the assets within each strategy Short-Term Bonds 8% RE–Global Public REITs 4%portfolio, optimizing the five parameters (return, risk, Int’l Developed Markets 5%liquidity, cash flow, and tax efficiency) for each of the U.S. Small Cap 1% Intermediate-Term Bonds 36%beneficiaries (self, spouse, children/heirs, society, and U.S. Mid Cap 1%government). A chart can help with this task. U.S. Large Cap 11% Int’l Developed Mkts Bonds 12% Long-Term Bonds 8% Basic Needs Lifestyle Philanthropy Legacy High-Yield Bonds 6%Return Goal inflation + 2% inflation + 5% inflation + 4% inflation + 6% Portfolio AllocationRisk Tolerance low medium high high Short-Term Bonds 8%Liquidity Needs high medium medium low Intermediate-Term Bonds 36% Long-Term Bonds 8%Cash Flow high medium medium low High-Yield Bonds 6%Tax Efficiency medium high low high International Developed Markets Bonds 12% U.S. Large Cap 11%Given these parameters, the Smiths and their investment U.S. Mid Cap 1%professional can develop strategic (long-term) asset U.S. Small Cap 1%allocation targets for each life span strategy portfolio. International Developed Markets 5% International Emerging Markets 0% Real Estate–Global Public REITs 4% Real Estate–Private REITs 0% Commodities 2% Complementary Strategies 6% Total 100% Total Return 6.22% Standard Deviation 4.55% Yield 4.23% Sharpe Ratio 0.60 Standard deviation. A statistical measure of the historical volatility of a mutual fund or portfolio, usually computed using 36 monthly returns. More generally, a measure of the extent to which numbers are spread around their average. Sharpe ratio. Ratio of the manager’s arithmetically annualized excess return over the annual standard deviation of the excess return. Excess returns are computed in comparison to the 3-month Treasury bill.4 February 2010 | Asset Allocation for Real-World Investors
  6. 6. Lifestyle strategy portfolio Philanthropy strategy portfolioBecause the basic needs strategy portfolio is designed Their philanthropy strategy portfolio needs to beto meet the Smiths’ shorter-term lifestyle needs, their designed to allow the Smiths to support their favoritelifestyle strategy portfolio does not need to provide a charities. A balance between growth and current incomehigh level of cash flow. It does, however, need to have is required. Hypothetically, the philanthropy portfolio’ssome liquidity for rebalancing and funding of the basic strategic asset allocation could be:needs portfolio, as required. Tax efficiency is critical. In our view, a more aggressive investment approach Philanthropy Strategy Portfoliodesigned for growth is in order for the lifestyle strategy Complementary Strategies 10%portfolio. The strategic allocation could be: Commodities 4% Short-Term Bonds 4% RE–Private REITs 4% Intermediate-Term Bonds 19%Lifestyle Strategy Portfolio RE–Global Public REITs 4% Long-Term Bonds 4% Int’l Emerging Markets 3% Short-Term Bonds 3% High-Yield Bonds 5%Complementary Strategies 12% Int’l Developed Markets 11% Intermediate-Term Bonds 13% Int’l Developed Mkts Bonds 8%Commodities 4% Long-Term Bonds 3% U.S. Small Cap 3% U.S. Large Cap 17%RE–Private REITs 5% High-Yield Bonds 4% U.S. Mid Cap 4%RE–Global Public REITs 5% Int’l Developed Mkts Bonds 6%Int’l Emerging Markets 3% Portfolio AllocationInt’l Developed Markets 13% U.S. Large Cap 20% Short-Term Bonds 4%U.S. Small Cap 4% U.S. Mid Cap 5% Intermediate-Term Bonds 19% Long-Term Bonds 4%Portfolio Allocation High-Yield Bonds 5% International Developed Markets Bonds 8%Short-Term Bonds 3%Intermediate-Term Bonds 13% U.S. Large Cap 17%Long-Term Bonds 3% U.S. Mid Cap 4%High-Yield Bonds 4% U.S. Small Cap 3%International Developed Markets Bonds 6% International Developed Markets 11% International Emerging Markets 3%U.S. Large Cap 20%U.S. Mid Cap 5% Real Estate–Global Public REITs 4%U.S. Small Cap 4% Real Estate–Private REITs 4%International Developed Markets 13% Commodities 4%International Emerging Markets 3% Complementary Strategies 10%Real Estate–Global Public REITs 5%Real Estate–Private REITs 5% Total 100%Commodities 4% Total Return 7.86%Complementary Strategies 12% Standard Deviation 8.20%Total 100% Yield 3.31% Sharpe Ratio 0.53Total Return 8.32%Standard Deviation 9.60%Yield 2.99%Sharpe Ratio 0.50 February 2010 | Asset Allocation for Real-World Investors 5
  7. 7. Legacy strategy portfolio The total-net-worth portfolioThe legacy strategy portfolio, a set of college savings When you add up all four strategy portfolios, the Smiths’plans, does not pay taxes, so tax efficiency is no longer total-net-worth portfolio is likely to look like the piean issue. Liquidity is not especially important because chart below:the grandchildren are still very young. Growth, however,is important because of rising tuition costs. For this The Total-Net-Worth Portfolioexample, the strategic asset allocation for the legacystrategy portfolio could be: Complementary Strategies 11.00% Short-Term Bonds 3.85% Commodities 3.70% Intermediate-Term Bonds 17.20%Legacy Strategy Portfolio RE–Private REITs 3.95% RE–Global Public REITs 4.75% Long-Term Bonds 3.85% Short-Term Bonds 1% Int’l Emerging Markets 2.90% High-Yield Bonds 4.35% Intermediate-Term Bonds 6% Int’l Developed Markets 11.50% Int’l Developed Mkts Bonds 7.00% Long-Term Bonds 1% U.S. Small Cap 3.45% U.S. Large Cap 18.25% High-Yield Bonds 3%Complementary Strategies 15% U.S. Mid Cap 4.25% Int’l Developed Mkts Bonds 3%Commodities 5%RE–Private REITs 5% U.S. Large Cap 22% Portfolio AllocationRE–Global Public REITs 5% Short-Term Bonds 3.85%Int’l Emerging Markets 8% U.S. Mid Cap 6% Intermediate-Term Bonds 17.20%Int’l Developed Markets 15% U.S. Small Cap 5% Long-Term Bonds 3.85% High-Yield Bonds 4.35%Portfolio Allocation International Developed Markets Bonds 7.00%Short-Term Bonds 1% U.S. Large Cap 18.25%Intermediate-Term Bonds 6% U.S. Mid Cap 4.25%Long-Term Bonds 1% U.S. Small Cap 3.45%High-Yield Bonds 3% International Developed Markets 11.50%International Developed Markets Bonds 3% International Emerging Markets 2.90%U.S. Large Cap 22% Real Estate–Global Public REITs 4.75%U.S. Mid Cap 6% Real Estate–Private REITs 3.95%U.S. Small Cap 5% Commodities 3.70%International Developed Markets 15%International Emerging Markets 8% Complementary Strategies 11.00%Real Estate–Global Public REITs 5% Total 100%Real Estate–Private REITs 5%Commodities 5% Total Return 8.38% Standard Deviation 9.68%Complementary Strategies 15% Yield 2.97%Total 100% Sharpe Ratio 0.50Total Return 9.39%Standard Deviation 12.44%Yield 2.40%Sharpe Ratio 0.476 February 2010 | Asset Allocation for Real-World Investors
  8. 8. These portfolios fall along the risk/return line as follows: 10 Lifestyle Legacy 9 8 Total Net WorthHypothetical Return 7 Philanthropy 6 Basic Needs 5 4 3 2 1 0 0 2 4 6 8 10 12 14 16 Hypothetical Risk This total-net-worth portfolio clearly represents a comprehensive view of the Smiths’ net worth. In our view, a single mathematical optimizer could not create that robust a portfolio. We believe that such a customized investment policy can be developed only through a disciplined behavioral-finance approach to identifying and addressing client goals, rigorous quantitative analysis to developing optimal portfolios, and prudent use of asset-class guideline constraints. In our example, some of the asset classes have very small allocations that are impractical to implement. Access to such asset classes can be achieved though hybrid investments, or simply by blending the small allocations into broader asset classes. The Smiths’ investment professional must truly understand their situation to be able to help them identify their unique investment goals, wants, and needs before allocating any assets. The Smiths should ask their investment professional to break down each strategy portfolio for them to make the process more accessible. Asset allocation is not simply creating pie charts based upon old-fashioned ideas of risk and return; rather, it is the process of converting their complex investment goals, requirements, and constraints into a customized investment strategy. We provide our clients with a holistic view of their financial portfolio. We do so by using sophisticated behavioral finance and asset allocation techniques. We invest client portfolios using a robust blended- architecture platform that includes a selection of highly competitive Wells Fargo and third-party money managers. This process brings the full resources of banking, credit, trust, and investments to help our clients achieve their multi-generational investment goals.
  9. 9. DisclosuresWells Fargo Wealth Management provides products and services through Wells Fargo Bank, N.A., Wachovia Bank, N.A. and their various subsidiaries and affiliates (including Wells Fargo Investments, LLC, memberSIPC, and Wells Fargo Advisors which are non-bank affiliates of Wells Fargo & Company).The information and opinions in this report were prepared by the investment management division within Wells Fargo Wealth Management. Information and opinions have been obtained or derived from sourceswe consider reliable, but we cannot guarantee their accuracy or completeness. Opinions represent Wells Fargo Wealth Management’s opinion as of the date of this report and are for general information purposesonly. Wells Fargo Wealth Management does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or haveopinions that are inconsistent with, and reach different conclusions from, this report.Past performance does not indicate future results. The value or income associated with a security or an investment may fluctuate. There is always the potential for loss as well as gain. Investments discussed in thisreport are not insured by the Federal Deposit Insurance Corporation (FDIC) and may be unsuitable for some investors depending on their specific investment objectives and financial position.The various outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. Other investment categories not considered may have characteristics similar orsuperior to those being analyzed.Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses. Your individual allocation may be different than the strategic long-termallocation presented due to your unique individual circumstances, but is targeted to be in the allocation ranges detailed. The asset allocation reflected above may fluctuate based on asset values,portfolio decisions,and account needs.This report is not an offer to buy or sell or solicitation of an offer to buy or sell any securities mentioned. Wells Fargo & Company and/or its affiliates or may trade for their own accounts, be on the opposite side ofcustomer orders, or have a long or short position in the securities mentioned herein.Investing in foreign securities presents certain risks that may not be present in domestic securities. For example, investments in foreign and emerging markets present special risks including currency fluctuation,the potential for diplomatic and political instability, regulatory and liquidity risks, foreign taxation and differences in auditing and other financial standards.Real estate investment carries a degree of risk and may not be suitable for all investors.Wells Fargo & Company and its affiliates do not provide tax or legal advice. Please consult your tax or legal advisors to determine how this information may apply to your own situation.On January 1, 2011, all provisions of the Tax Relief Act will expire, and qualified education expenses may be subject to federal tax unless their provisions are extended or changed by federal legislation. Allnon-qualified withdrawals are subject to federal and state income tax and a 10% penalty.State tax treatment of earnings may vary. As with any investment, your withdrawal value may be more or less than your original investment.Additional information is available upon request. PI21009 (201002088 02/10)