Your investing strategy likely includes more than purchasing only stocks or index funds. You may also be looking at bonds or cash investments. This approach to investing, dividing funds between equities, bonds, and cash investments, is known as asset allocation.
However, building a successful investment portfolio requires more than the basics of this strategy. Leveraging the two types of this approach, strategic asset allocation and tactical asset allocation, provides the tools you need to balance your portfolio.
Key Takeaways
- Strategic asset allocation is a long-term investment strategy focusing on an optimal asset mix based on risk tolerance, liquidity, and time horizon. Tactical asset allocation involves a short-term mindset of regularly rebalancing assets in hopes of capturing gains from market volatility.
- Strategic and tactical strategies couldn’t be more different. Strategic asset allocation is long-term, while tactical asset allocation focuses on the short term. Strategic allocation is more stable but restricted, whereas the tactical method is more flexible, time-consuming, and expensive.
- A fiduciaries financial advisor may employ either strategy to optimize a portfolio, depending on market stability, risk tolerance, and financial goals.
Understanding Asset Allocation
Asset allocation is the process of balancing an investment portfolio to minimize risk and maximize returns. Although advisor approaches may differ, asset allocation is a bedrock investing concept that applies to all investment plans. It involves diversification, measuring risk tolerance, and managing investment goals.
How is Asset Allocation Different From Diversification?
It’s important to note that asset allocation is similar to but not exactly the same as diversification. Remember, the point of asset allocation is to determine what percentage of a portfolio should be dedicated to various stock, bond, alternatives, and cash asset categories. In a sense, this is diversifying a portfolio. However, diversification typically goes beyond asset allocation in determining how to spread a portfolio’s holdings within each asset category among enough specific stocks, bonds, and alternatives to avoid concentrations.
For example, you might develop an asset allocation that calls for investing 15% of the portfolio in large cap US growth stocks. How you take that 15% “allocation” and decide how many large cap US growth stocks to actually buy, which industry sectors to include, and how much exposure you want to each one is “diversification.”
Asset allocation is used for long-term investment strategies because it assists investors in navigating market uncertainty and maintaining alignment with their financial goals. It is critical to the success of any investment plan, and as a result, fiduciaries must take great care in regularly reviewing and rebalancing assets.
However, there’s more than one type of asset allocation. We will focus on two central strategies: Strategic and Tactical.
What is Strategic Asset Allocation?
Strategic asset allocation is a long-term investment approach emphasizing stability over short-term gains. An advisor uses this method to set an optimal asset mix based on several factors, such as investor risk tolerance, liquidity needs, and time horizon. This type of portfolio makes it easier for investors to ride out short-term market volatility and manage long-term financial goals.
The main reasons to use this strategy are the potential for:
- Reducing the impact of market volatility
- Enhancing risk-adjusted returns
- Providing a clear investment roadmap
- Avoiding emotional decision-making that might hinder portfolio growth
One typical example is the 60/40 portfolio. Stemming from the 1950s work of Nobel laureate Harry Markowitz, the 60/40 portfolio dictates that 60% of investments should be in stocks and 40% in bonds for optimal performance.
This model continues to be popular: 71% of investment professionals surveyed in 2023 believe that the 60/40 model will likely provide returns similar to historical returns.
What is Tactical Asset Allocation?
In contrast to the Strategic method, tactical asset allocation is a short-term technique that tries to take advantage of perceived short-term irregularities in various asset categories. The goal is to either reduce volatility or improve returns by taking advantage of the perceived irregularity in the market.
There are two general types of tactical asset allocation:
- Discretionary tactical asset allocation: This adjusts assets based on market valuations or changes in the market.
- Systematic tactical asset allocation: This requires investors to adjust their portfolios based on a quantitative investment model, which should enable them to identify potential inefficiencies or imbalances.
Is the tactical method more akin to gambling? After all, no one can predict market shifts. Famous examples popularize this misconception. Consider the book and film The Big Short, which documents how fund manager John Paulson shorted the housing market just before the 2008 financial crisis.
The tactical method is a legitimate strategy, but it’s not nearly as glamorous as movies suggest. In a recent Journal of Financial Risk Management study, researchers found that tactical asset allocation can potentially improve returns, even when including deviations. However, it is a riskier strategy and should not be used for long-term investments.
Comparing Strategic and Tactical Approaches
Strategic and tactical strategies couldn’t be more different. Strategic asset allocation is long-term, while tactical asset allocation focuses on the short term. Strategic allocation is more stable but restricted, whereas the tactical method is more flexible, time-consuming, and expensive.
Nevertheless, there are strategic times to use each approach:
- Strategic asset allocation is appropriate for long-term investment strategies with lower risk tolerances.
- Tactical asset allocation is appropriate for short-term goals and higher risk tolerances.
The Pitfalls of Asset Allocation
Both strategies have their place, but as with all approaches, they have unique downsides.
The strategic method can backfire if liquidity needs have not been considered. Liquidity means having enough cash to meet withdrawal needs. Without factoring in liquidity, investors could be forced to sell investments during a market downturn or may be stuck with undesirable or difficult-to-sell assets, such as real estate.
Tactical asset allocation requires a higher risk tolerance because it is easy to take it too far. Investors are prone to more emotional decision-making, allowing them to slip into “market timing.” Market timing has consistently failed over time because it has less than a 4% margin of error. In other words, if you miss just 4% of the best days in the market, your return will be less than if you had invested in treasury bonds. However, you would still have experienced the volatility of an equity-heavy portfolio. It is the worst of both worlds.
There is also a higher probability that tactical asset allocation may simply fail, even if you haven’t slipped into market timing. Past studies have shown that tactical asset allocation funds may actually provide lower returns for greater risk and higher fees. According to a Morningstar study, the average expense ratio for tactical asset allocation funds was 50% higher than for strategic asset allocation funds.
Effective Implementation
To effectively implement an asset allocation strategy, an investor must first determine their:
- Risk tolerance
- Investment goals
- Liquidity needs
- Time horizon
These elements enable better decisions regarding an optimal asset mix. Of course, the work doesn’t end there. Investors must regularly review and rebalance a portfolio to ensure it remains aligned with the desired asset allocation.
Best practices for portfolio rebalancing
Rebalancing involves buying or selling assets regularly to maintain a target asset allocation and minimize drift. Drift is when your portfolio holdings deviate from the desired asset balance. For example, you may prefer to have 60% of your assets in stocks and 40% in bonds. If you earn more in bonds and suffer losses in the stock market, your portfolio may drift to 50% stocks and 50% bonds. In this case, you should rebalance your portfolio to offset the drift. This drift will inevitably expose your portfolio to excess risk and volatility if not corrected.
Whether your approach is strategic or tactical, you must rebalance your portfolio at some point. The difficulty in rebalancing is psychological; it requires selling some of your “winning” categories and buying some of your “losing” categories. For example, if your stocks are doing really well and bonds are doing poorly, rebalancing would mean selling some of the stocks and buying more bonds. That can be tough to do, especially if the media coverage is exaggerating how bad the economy is at that time.
Overcoming Common Challenges
As with any investing strategy, there are some common pitfalls. In particular, it’s essential to consider the emotional aspect of investing. Emotional decision-making can lead to deviation from long-term investment strategies, create imbalances in your portfolio, and increase the risk of lower returns.
Asset allocation can help in this respect. When you allocate and diversify your portfolio, you include various asset classes to minimize risk and increase potential returns. This approach helps to stabilize a portfolio, thus reducing the likelihood of emotional decision-making.
It’s also important to note that you can use asset allocation strategies in tandem. For example, you can have a primarily strategic asset allocation strategy but use a tactical method when rebalancing or during periods of high volatility.
Real-World Strategic vs Tactical Asset Allocation Examples
Let’s examine two hypothetical situations where these strategies can be used in the real world. This will help further demonstrate the differences between strategic and tactical asset allocation.
Strategic Asset Allocation
Steve is saving for retirement. He works with a registered investment advisor (RIA) to design an investment plan and diversified portfolio. Steve plans to kick off his investment with $500,000 to hold over twenty years and has a low-risk tolerance. As a result, Steve’s allocations are 40% fixed income, 50% stocks, and 10% alternative asset because Steve and his advisor have determined that this long-term allocation should generate the average return he wants within his risk tolerance.
Tactical investment strategies operate differently. For instance, an RIA or individual investor is less likely to employ this strategy regularly.
Tactical Asset Allocation
Consider Fiona, who also has a long-term goal and has worked out a strategic allocation with her advisor designed to optimize returns and risk tolerance as Steve has. However, Fiona and her advisor have concluded that interest rates are at such historically low levels that the odds are overwhelmingly high that interest rates will rise. Because long-term bonds are hit harder than short-term bonds, Fiona and her advisor decide to shift her bond portfolio from long-term to short-term without really decreasing the percentage allocated to bonds. In other words, the long-term allocation to bonds is maintained, but within bonds, she makes a tactical allocation decision to favor short-term bonds instead of long-term bonds.
When successfully implemented, the differences between these approaches are evident:
- Strategic asset allocation provides a more stable, long-term portfolio with a passive investing style.
- Tactical asset allocation provides flexibility and potentially higher returns but with higher fees and volatility.
Regardless of your strategy, you must review and rebalance your portfolio regularly.
Mastering Asset Allocation for Investing Success
The professional investment mindset centers around asset allocation, and for good reason. This method encompasses diversification and aligns investments with financial goals, risk tolerance, and liquidity needs. Asset allocation is the backbone of any investment strategy.
Your specific allocation will depend on your goals. Strategic asset allocation offers a long-term foundation, while tactical asset allocation offers flexibility and potentially better short-term returns but at greater risk.
Ultimately, you should focus on balance. A balanced investment strategy that combines both tactics can help you recognize your long-term financial objectives while minimizing risk. Understanding the key differences between strategic and tactical allocations can help you tap into diversification and opportunities for growth.
Anyone can set their portfolio’s asset mix, but it helps to have a second opinion. Speaking with an expert can help you balance investment strategies and remove potential emotional decision-making.
If you’d like to tap into our expertise, click the button below to schedule a complimentary appointment with a 100% objective, fiduciary, fee-only financial advisor.
Greg Welborn is a Principal at First Financial Consulting. He has more than 35 years’ experience in providing 100% objective advice, always focusing on the client’s best interests.
Greg Welborn is a Principal at First Financial Consulting. He has more than 35 years’ experience in providing 100% objective advice, always focusing on the client’s best interests.
