Tactical asset allocation is a departure from the conventional strategic asset allocation, or 'buy-and-hold' strategy. It actively manages a portfolio's mix of assets based on short-term market conditions, leverages known market anomalies, including momentum, mean-reversion, and sector rotation for potential gains, and is geared toward mitigating downturns. While a buy-and-hold approach, rooted in the Efficient Market Hypothesis, suggests long-term stability, tactical asset allocation adapts to shorter time horizons and focuses on enhancing risk-adjusted returns. However, these strategies demand expertise, can be time-consuming, and require considerations about taxes and frequent transaction costs.
The Traditional Approach
The Efficient Market Hypothesis suggests that security prices adjust quickly and fully reflect all new information. In these efficient markets picking stocks randomly is as good as any other method for investing. In other words, it is impossible to beat efficient markets.
Diversification is fundamental in constructing long-term portfolios, pioneered by Harry Markowitz and his Modern Portfolio Theory. Markowitz introduced mean-variance optimization and the Efficient Frontier: portfolios along this line maximize the return per unit of risk. He calculates the Efficient Frontier from the estimated returns of the portfolio assets and the covariance matrix describing their correlation. Combining these two views is called Strategic Asset Allocation, and this type of portfolio is ubiquitous, the 60/40 being the most famous example.
A New Strategy: Shorter Time Horizons and Tactical Asset Allocation
Tactical asset allocation stands in contrast to the 'buy-and-hold' approach. Through active portfolio management, it takes advantage of known market anomalies such as momentum, mean-reversion, and sector rotation.
Momentum suggests that price trends established in the past often persist into the future. Though it doesn't predict the future outright, it does offer a slight advantage by highlighting assets with historical momentum. Identifying market sentiment, such as enduring bullish markets or brief periods of recession-based losses, further supports the presence of this momentum anomaly.
Mean reversion centers around assets that, after experiencing brief but significant deviations from their mean rate of return, tend to revert to that mean. Experts often attribute this to behavioral finance, where markets overreact to news. This anomaly is particularly effective in volatile markets, allowing for swift entry and exit from assets within a few days.
Sector rotation takes advantage of the assumption that the various economic sectors' returns are dependent on the overall economic cycle. We can realize excess profits by rotating from one sector to another at the right time.
These anomalies reveal that past price trends often persist into the future and can provide lucrative opportunities.
Benefits and Considerations of Tactical Asset Allocation
TuringTrader.com advocates tactical asset allocation because we believe it provides tremendous value for investors. About once a decade, the economy enters a recession, investors can face losses of 30% or more, and it might take many years to recover from these drawdowns. Actively managed portfolios can help reduce tail risk in recessions and improve your risk-adjusted return. Reducing drawdown shortens the minimum investment horizon and might be more important than absolute returns, especially when you enter retirement.
We like to see tactical asset allocation as a new approach to diversification. We find that strategies are often only loosely correlated and have specific market conditions under which they strive. Instead of diversifying across asset classes, we can also diversify by employing multiple strategies simultaneously. For example, combining momentum and mean-reversion strategies can turn into positive returns in trending and sideways markets.
The Fine Print
It sounds quite tempting to profit from active portfolio management. However, tactical asset allocation requires expertise and is time-consuming. Along with the actively managed portfolio come many transactions, each costing fees and commissions. Furthermore, active management may lead to short-term capital gains and wash sales. We pay the individual tax rate for short-term capital gains, which tends to be higher than long-term capital gains: The latter rate maxes out at 20%, based on your income. Wash sales disallow investors to harvest tax losses when entering substantially identical securities within 30 days. Both tax implications require consideration.
Another aspect to consider is emotional. While it feels good to be in control of your financial destiny, there will inevitably be times when things don't go as expected. Investors often overestimate their risk tolerance until they experience losses. Losing money is very painful and can cause anxiety. Therefore, one of the most significant benefits of tactical asset allocation may be reduced portfolio volatility. However, this reduced volatility creates another trap: the fear of missing out. Reducing volatility often follows the approach of making more by losing less. Tactical portfolios tend to lose less during a recession but often trail passive strategies during bull markets. It requires discipline to stay the course while trailing plain portfolios for several years.
TuringTrader.com
TuringTrader.com simplifies tactical asset allocation and active portfolio management for various investment objectives. We provide standardized portfolio presentations, reviews, and comprehensive background information to facilitate an easy selection and comparison. Once you've selected a strategy, investing through TuringTrader.com is straightforward, allowing you to navigate the complexities of tactical asset allocation effortlessly.