1. Asset Allocation for Real-World Investors
February 2010 In this special report
Prepared by 1 Combining modern portfolio theory and behavioral finance
Ronald Florance, CFA ®
2 Behavioral finance
Director of Investment Strategy
& Asset Allocation 3 A case study of Julie and Josh Smith
Anne Symanovich 3 What is the money for?
Senior Investment Research 4 Basic needs strategy portfolio
Analyst
5 Lifestyle strategy portfolio
5 Philanthropy strategy portfolio
6 Legacy strategy portfolio
6 The total-net-worth portfolio

2. Asset Allocation for Real-World Investors
As an individual investor you likely expect your Typically, investment professionals determine an
portfolio to meet a variety of needs or goals. When an investor’s level of risk tolerance and then select the
investment professional determines what an investor’s corresponding combination of asset classes on the
strategy 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 would
to 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 when
investor has one, and only one, level of risk tolerance.
it was first developed in the 1950s and 1960s. Institutional
However, in reviewing your portfolio, you may realize
investors were the first to embrace the methodology. It
that you do not have just one investment goal or level
revolutionized the way that such investors developed
of 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 portfolio
goals 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 potential
life 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 only
your lifestyle, education, retirement, philanthropic, and about General Electric vs. General Motors, but about
legacy 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 to
your unique risk, return, liquidity, cash flow, and tax
institutional money management. Portfolios for
requirements for that goal. So when someone asks what
pensions, endowments, and foundations have a defined
your risk tolerance is, the answer ought to be, “That
investment goal. These institutions generally have a set
depends on which pool of assets you are asking about.”
amount of assets (the portfolio size) and a well-defined
This 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 trade
approach to develop a comprehensive investment at low transaction costs. Given this asset/liability
strategy to suit your individual financial needs and optimization model, creating optimal portfolios based
objectives. When applying this approach, you begin upon risk and return works well. The level of risk is
by determining the life span needs, or goals, that your commonly set by determining the level of risk needed to
portfolio must address and then allocate specific assets hit the minimum return requirement to satisfy the
to 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 individual
and 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 investor
asset 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 based
portfolio 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 multiple
return for a given level of risk. Using different relationships. As an investor, you may have multiple
combinations of diverse asset classes, an investment goals, and different levels of risk tolerance and return
professional can create an efficient frontier—a series of requirements for different pools of wealth. Behavioral
optimal, return-maximizing portfolios representing finance can help develop an effective investment
different degrees of risk. strategy within a multiple-investment-goal environment.
February 2010 | Asset Allocation for Real-World Investors 1

3. Behavioral finance mean-variance analysis can be combined in a way that
Behavioral finance bridges the gap between modern satisfies both the academic integrity of your investment
portfolio theory optimization and real-world investors. strategy and your emotional needs.
By understanding that you may have more than one
investment goal and that risk and return are not the Our Starting Point: What is the Money for?
only parameters about which you are concerned, your
investment professional can develop an investment
Legacy
strategy that is more suitable for your complex needs.
Behavioral finance looks at the multi-dimensional
investment goals of investors. By articulating and Philanthropy
quantifying the various obligations on an investment
portfolio, identifying appropriate risk/return
Lifestyle
requirements, looking beyond risk/return to other
investment parameters, and developing appropriate
investor expectations, the science of behavioral finance
Basic Needs
can help develop a more personalized investment
strategy that has a greater probability of meeting your
specific needs.
This diagram highlights the major requirements or
So 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, and
necessarily hold true in real life. For example, it assumes
immediate lifestyle necessities
that the pain that you feel if a stock or asset class falls
by a certain amount is equivalent to the joy you may 2. Lifestyle. Maintaining a satisfactory lifestyle
experience if the stock or asset class rises by a similar throughout your life
amount. We do not believe that this is a true reflection 3. Philanthropy. Supporting specific causes or charities
of human nature. In our view, the loss of a dollar 4. Legacy. Making significant bequests during or after
generally creates more pain than the joy created from your lifetime
making a dollar.
Within these categories, there are five sets of beneficiaries
Economic and financial theories also assume that investors that you may need to consider:
tend to act rationally when it comes to investments. 1. Yourself
However, many studies show that investors tend to pile
2. Spouse/partner
into hot asset classes and investments just as they are
ready to fall. These investment decisions are based on 3. Children/heirs
herd-mentality emotion, as opposed to sound invest- 4. Society
ment and valuation analysis. Investors may intuitively 5. Government
know 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 optimized
academic 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 return
These are the types of behaviors that can result in 2. Risk. The potential fluctuations in the value of your
inappropriate investment strategies for certain investments, which could result in losses
investors. A portfolio may appear to be invested 3. Liquidity. The degree to which you need your
prudently from a statistical point of view, but it may portfolio assets to be easily convertible to cash
not capture the multiple risk tolerance levels that 4. Cash flow. Your need for reliable cash flows
many investors may have. Valuations of investments from your portfolio
may lead to a strategy that does not satisfy the true
5. Tax efficiency. Your need to reduce the impact of
nature of individual investors. We believe that
taxes on your after-tax portfolio returns
behavioral finance, modern portfolio theory, and
2 February 2010 | Asset Allocation for Real-World Investors

4. You should consider all the requirements listed above in This couple will need the help of a wealth-planning
consultation with your investment professional. In strategist to ensure that the estate plan and investment
addition, 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 in
modern portfolio theory risk/return optimization; it developing the legal structure to help the Smiths ensure
requires a better understanding of what you want your a smooth transition of assets as their lives progress.
investments to achieve for you. This is where behavioral Although financial-planning topics are beyond the
finance is required. scope of this special report, we’d like to stress that using
wealth-planning strategists is vital for the development
A behavioral finance approach to asset allocation
of a successful investment strategy.
involves three stages. In the first stage, you apportion
your assets across the four need categories listed on Now that the Smiths have decided upon their basic
page 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 the
maximize the probability of achieving your desired assets amongst the four life-span needs categories or
financial 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 four
portfolio is appropriate for your family’s total wealth
times their annual living expenses to meet their basic
situation. 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 typically
A case study of Julie and Josh Smith
would replenish their basic needs strategy portfolio with
Julie and Josh Smith have worked hard, raised three assets from the lifestyle strategy portfolio. Setting aside
children, and accumulated substantial wealth. They are enough assets to cover four years of living expenses is
in their late 50s, enjoy very good health, and are in a likely to allow the Smiths to rebalance the lifestyle
life transition. They no longer plan on accumulating strategy portfolio without being forced to liquidate its
significant assets but would like their investment assets during unfavorable market conditions.
portfolio to support the various financial goals that they
have at this stage in their lives. All their children are The Smiths indicated that they would like to leave a
married and doing well. Each has one child, with more legacy of $100,000 to support their grandchildren’s
coming 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 philanthropy
What 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 in
They 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 the
like to set aside $50,000 to generate income so they Smiths consume every year from their basic needs
can make regular donations to charities with which strategy portfolio.
they are involved. The Smiths also would like to
contribute $100,000 to a series of college funds for
their grandchildren.
February 2010 | Asset Allocation for Real-World Investors 3

5. In summary, the asset allocation across the life-span Basic needs strategy portfolio
strategy portfolios is: The basic needs strategy portfolio is designed to
potentially offer very low volatility, with adequate
Life Span Asset Allocation
liquidity and cash flow to cover the Smiths’ day-to-day
Philanthropy $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 $100,000
Lifestyle $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 Allocation
Risk 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. Lifestyle strategy portfolio Philanthropy strategy portfolio
Because the basic needs strategy portfolio is designed Their philanthropy strategy portfolio needs to be
to meet the Smiths’ shorter-term lifestyle needs, their designed to allow the Smiths to support their favorite
lifestyle strategy portfolio does not need to provide a charities. A balance between growth and current income
high level of cash flow. It does, however, need to have is required. Hypothetically, the philanthropy portfolio’s
some 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 Portfolio
designed 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 Allocation
Int’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 0.53
Total Return 8.32%
Standard Deviation 9.60%
Yield 2.99%
Sharpe Ratio 0.50
February 2010 | Asset Allocation for Real-World Investors 5

7. Legacy strategy portfolio The total-net-worth portfolio
The 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 pie
an 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 Portfolio
example, the strategic asset allocation for the legacy
strategy 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 Allocation
RE–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 0.50
Total Return 9.39%
Standard Deviation 12.44%
Yield 2.40%
Sharpe Ratio 0.47
6 February 2010 | Asset Allocation for Real-World Investors

8. These portfolios fall along the risk/return line as follows:
10 Lifestyle Legacy
9
8 Total Net Worth
Hypothetical 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. Disclosures
Wells 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, member
SIPC, 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 sources
we 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 purposes
only. 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 have
opinions 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 this
report 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 or
superior 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-term
allocation 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 of
customer 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. All
non-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.
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