Tactical Asset Allocation: a Strategy to Stay Ahead of the Herd

Posted by Alex Frey (@alexhfrey )

The last article discussed strategic asset allocation (SAA), which is the first major asset-allocation theory. Strategic asset allocation is still the approach favored by the majority of financial advisors and investing gurus. But not everyone agrees with the tenets of SAA. 

Opponents to SAA mostly advocate some form of tactical asset allocation (TAA). 

What is Tactical Asset Allocation?

"Tactical Asset Allocation" is more clearly defined by what it is not than by what it is. What tactical asset allocation is not is strategic asset allocation. What it is not is having a static asset allocation that does not change based on what is going on in the markets. What it is not is believing that it is pointless to try to do any better than the markets over time.

What tactical asset allocation is, is a belief that investors can and should "time the markets" to some degree by shifting their allocations to asset-classes based on an estimation of returns for some future time period.

Another way to think about the differences between tactical and strategic asset allocation is to think about them as being fundamentally a difference about the time frame that you should think about investing over. 

The time period that strategic asset allocation operates over is essentially "forever" - adherents believe that nobody has much of an ability to "time the markets" and predict returns in the short-term, we can only be assured that in the long-term, risk assets will tend to inexorably go up. 

Adherents to tactical asset allocation are willing to take a view of the markets over some time period that is not "forever." Depending on the specific approach, this time frame can range from a few weeks, to the better part of a decade. Whatever the time frame, tactical investors believe that they can use current market conditions to make informed guesses about the range of expected returns over this time scale, so they see no reason not to adjust their positions accordingly. The strategic crowd -- TAA proponents claim -- might be right in the long term, but "in the long term, we are all dead."  

Apart from being opposed to strategic asset allocation though, there is not a whole lot that holds tactical asset allocation strategies together. Specific tactical strategies can be based on all kinds of different factors, some of them fundamental and others purely technical or systematic. However, many tactical asset allocation strategies employ a momentum-based strategy of holding assets that have performed well in recent periods and selling those that have not done well. 

Exploiting market anomalies like momentum is one way that tactical proponents might be able to edge out supporters of SAA, but there are other ways too...

Arguments for Tactical Asset Allocation vs. Strategic Asset Allocation

Adjusting asset allocations based on a somewhat shorter-term view of the markets has several potential advantages:

  • A tactical approach can take advantage of momentum and other short-term market anomalies. Recent academic research strongly suggests that several "market anomalies" do exist, including the well-known momentum effect. This opens up the door to the possibility of doing better than a purely "static" approach.
  • The tactical approach allows for more sophisticated risk management techniques. Strategic approaches do not protect investors from the massive bear markets that seem to occur every decade or so. A bear market that occurs at the wrong time can be devastating to the retirement hopes of a buy-and-hold investor. Successful TAA approaches may enable more advanced risk-management techniques.
  • The tactical approach may be easier to follow and stick with in a real-money portfolio. A problem with the large drawdowns (losses) that are pretty much inevitable with a SAA approach is that many individual investors become fearful and end up making a huge investment mistake and selling near a bottom of a bear market. In other words, they find SAA nearly impossible to stick with in a real-money portfolio. This explains the so-called "behavior gap:" the returns of average investors fall far short of the returns of the overall market.

Of course, the tactical approach is no panacea, and even if successful over the long-term, it can have long periods of under-performance, as has been obvious lately...

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By Alex Frey