Strategic Asset Allocation Versus Tactical Asset Allocation

Asset allocation is how investors proportion their investment dollars to specific asset classes. This division of capital allows for proper risk management: It divvies up investments into stocks, bonds and other assets to maximize returns given time considerations and risk tolerance. Typically, aggressive investors with long time windows invest heavily in stocks, while more conservative investors with a nearer goal in mind allocate more money to bonds.

What Is Tactical Asset Allocation?

Tactical asset allocation is a short-term to intermediate-term investment view that looks for opportunities the market presents. It’s an active portfolio management strategy that shifts the percentage of one’s assets held in various categories to take advantage of perceived anomalies or strong market sectors.

For instance, an investor who thinks the market is undervalued might rebalance their portfolio to increase stock holdings while reducing positions in bonds. The opposite is also true. Years into a bull market, or when the stock market reaches all-time highs and stocks may be considered expensive, a tactical asset allocator may shift money from stocks to bond holdings on the assumption that stock prices will either “correct” or experience a period of middling performance.

Tactical asset allocation can also involve shifting holdings within a specific asset class. An investor watching growth stocks soar might choose to reduce consumer cyclical holdings and buy additional tech shares. Those assuming small-cap undervaluation may relocate large-cap holdings into smaller companies that they think will outperform in the coming months or years.

These tactical shifts usually involve reallocation of 5% to 10% of the portfolio. Moving an amount larger than that carries additional risk by deviating further from optimal portfolio allocation given time frame and risk tolerance.

Importantly, tactical asset allocation differs from rebalancing a portfolio. Portfolio rebalancing involves executing trades to return overall holdings to desired strategic asset allocation. Shifting assets to capitalize on pricing anomalies involves short-term deviation from strategic asset allocation, with the intent of returning to it once those opportunities disappear.

The advantages of tactical asset allocation are fairly obvious. Correctly shifting money from underperforming asset classes and into overperforming ones increases overall portfolio returns and possible market outperformance.

There are, however, many disadvantages of tactical asset allocation. Few experts endorse this approach because investors generally overestimate their ability to identify market or sector lows and highs. This means investors may not actually identify anomalies and may not benefit from them. Such an active approach also involves additional tax burden if shares are held for less than one year. Higher tax rates coupled with the potential for incorrectly timed trades might well make tactical asset allocation underperform strategic asset allocation.

What Is Strategic Asset Allocation?

Strategic asset allocation is a portfolio management strategy where an investor sets target allocations for asset classes and occasionally rebalances their portfolio to maintain that allocation. As mentioned, specific asset class targets depend on the investor’s risk tolerance, time horizon and investing goals.

Generally, this is a longer-term, buy-and-hold strategy that contrasts with the active approach of tactical asset allocation. It focuses on maintaining long-run diversification, which might mean occasionally divesting from hot sectors to keep the identified balance. Strategic asset allocators do not look to exploit market anomalies.

On its surface, this is a simple strategy. An investor with a 60/40 portfolio (60% stock and 40% fixed income) would typically rebalance once a year to maintain that allocation. On a $100,000 portfolio, $60,000 would go to a mix of stocks and $40,000 to fixed income. If the two asset classes grow 10% and 3%, respectively, the portfolio’s balance reaches $107,200 the following year and target allocation becomes $64,320 and $42,880. That means the investor sells $1,680 of stock ($66,000 current allocation minus $64,320 target) and invests it in fixed-income assets. AAII can help investors determine the proper asset allocation targets for their risk and time frame.

The advantages of strategic asset allocation include its simplicity (adjusting a portfolio annually versus continually monitoring the market), tax advantages and consistency. Those benefits make it the preferred approach of most investors, especially with the advent of low-fee, index-tracking exchange-traded funds (ETFs).

Disadvantages of strategic asset allocation center on returns limited by market performance. Because investors simply buy and hold securities within each asset class, they cannot beat the market. It precludes capitalizing on anomalies and relies on investors accurately pegging their optimal asset allocation when setting up their portfolio.

How to Decide Which Asset Allocation Tactic Is Right for You

As with all investing decisions, determining which asset allocation tactic is right for you depends on your goals, risk appetite and interest in active investing. Those seeking to outperform the market—whether to increase financial security, retire early, etc.—may want to try tactical asset allocation. Those who don’t want to risk underperformance by reallocating to the wrong sector likely will choose strategic asset allocation. Similarly, if you want to buy and forget about your investments for a year, strategic asset allocation is likely the right choice.

Be sure to understand the pros and cons of both, identify your goals and plan accordingly so that you can properly manage either decision. AAII can help with all of the above while providing additional investment education that sets you on the path toward financial fulfillment. See how AAII membership can help you become a better investor by clicking here.

Discussion