A proactive portfolio management strategy that adjusts a portfolio’s mix of asset classes in consideration of short-term market conditions is known as tactical asset allocation. Tactical asset allocation intends to improve a portfolio’s risk-adjusted return.
Efficient Markets and Strategic Asset Allocation
Many investors with a long-term investment horizon choose a traditional approach with a strategically composed and diversified portfolio. They justify this investment approach with the Efficient Market Hypothesis and the assumption that returns, volatility, and correlations are, in the long term, relatively stable.
The Efficient Market Hypothesis suggests that security prices adjust quickly to new information and fully reflect all available information. In these efficient markets, randomly picking stocks is as good a method as any other investment. In other words, it is impossible to beat efficient markets.
However, strategic asset allocation is still far from random: Diversification is a widely accepted approach to constructing portfolios. This approach goes back to Harry Markowitz and his Modern Portfolio Theory. Markowitz introduced mean-variance optimization and the concept of the Efficient Frontier. Portfolios along the Efficient Frontier maximize the return per unit of risk. Markowitz calculates the Efficient Frontier from the estimated returns of the portfolio assets, and the covariance matrix describing the correlation between these assets.
Combining these two views leads us to Strategic Asset Allocation. Portfolios based on this mindset are ubiquitous, the 60/40 being one of the most prominent examples.
Shorter Time Horizons and Tactical Asset Allocation
While we generally believe in efficient markets, there are cracks in this foundation. Markets display some known anomalies, and correlations between asset classes are far from stable. Tactical Asset Allocation attempts to take advantage of this by replacing buy-and-hold with active management.
The premier anomaly of efficient markets is momentum. Price trends established in the past tend to extend into the future. And while momentum is by no means predicting the future, after all, day-to-day price moves remain fairly random. However, we can establish a slight edge by picking assets based on their historical momentum. Market sentiment, e.g., bullish markets that keep going for several years, and shorter periods of recession-based losses are another indication of the momentum anomaly.
Short-term mean-reversion is another established anomaly of otherwise efficient markets. Mean reverting assets tend to revert to their mean rate of return, after short and pronounced deviations from that mean. Experts often explain this anomaly with behavioral finance and markets overreacting to news. Exploiting this anomaly works particularly well in volatile markets and leads to entering and exiting assets within a matter of only a few days.
Another technique used in active portfolio management is sector rotation. The underlying assumption is that the returns of the various economic sectors are dependent on the overall economic cycle. We can realize excess profits by rotating from one sector to another at the right time.
The Benefits of Tactical Asset Allocation
At TuringTrader.com, we believe that looking beyond the traditional buy and hold investment approaches and adopting technical asset allocation provides tremendous value to investors. With active portfolio management, we can create portfolio characteristics, which can’t be achieved by passive means.
About once per decade, the economy enters a recession. During these periods, investors face losses of 30% or more percent of their capital, and it can take many years to recover from these drawdowns. There will always be another recession in the future, and actively managed portfolios can help reduce tail risk and with that impeocw your risk-adjusted return. Reducing drawdowns shortens the minimum investment horizon, and with that allows you to reduce the amount set aside in your rainy day fund. Also, reduced drawdowns might be more important than absolute returns, when living off of your savings.
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. As an example, combining momentum and mean-reversion strategies will lead to portfolios, which provide 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 on a daily basis. 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. For short-term capital gains, we pay the individual tax rate, which tends to be higher than the rate for 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 of these 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 the way we hoped they would. 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. Portfolios of this kind tend to lose less during a recession, but often trail passive portfolios during bull markets. It requires much discipline to stay the course while trailing simpler portfolios for several years.
At TuringTrader.com, we aim to simplify tactical asset allocation and the process of actively managing your portfolio. We strive to present our portfolios in standardized ways, to allow easy selection and comparison. Also, we provide our review and opinion, to point out some details which you might otherwise miss. Further, we provide background information and references to jump-start your in-depth research. And once you made a decision, TuringTrader.com makes investing in these portfolios as simple as possible.