What Is Tactical Asset Allocation?

Definition and Example of Tactical Asset Allocation

A TAA strategy focuses on keeping the ideal mix of asset types to fit your desired risk level. It requires actively watching how different asset classes perform, and then adjusting a portfolio's allocations accordingly.

Instead of simply deciding on an asset mix and sticking to it, you would choose an initial blend. Then, you would wait to see whether it performs as expected. If it doesn't, you would shift the proportions of stocks, bonds, and cash to better fit your desired returns.

How Does TAA Work?

Using TAA, you may arrive at a prudent mix of assets suitable for your risk tolerance and objectives. For example, if you choose a moderate portfolio allocation, it may have a target of 65% stocks, 30% bonds, and 5% cash.

The part of this investing style that makes it tactical is that the allocation will change, depending upon the prevailing (or expected) market and economic conditions. Depending on these conditions and your objectives, the allocation to a particular asset (or more than one asset) can be either neutral-weighted, over-weighted, or under-weighted.

For instance, let's look at the 65/30/5 allocation given above. This is a target; all of the assets are "neutral-weighted." Suppose that market and economic conditions have changed; valuations for stocks become relatively high, and a bull market appears to be in the maturity stages. At that point, you may think stocks are overpriced and that a negative environment is near. You may then decide to begin taking steps away from market risk and toward a more conservative asset mix, such as 50% stocks, 40% bonds, and 10% cash.

In that scenario, you have under-weighted stocks and over-weighted bonds and cash. You'd continue to reduce risk in steps if it appeared that a bear market and recession were drawing closer. You may attempt to be almost entirely invested in bonds and cash by the time bear market conditions are evident. At that time, you'd consider slowly reallocating to your stock positions in preparation for the slow climb that is a bull market.

It is important to note that TAA differs from market timing, because this method is slow, deliberate, and methodical. On the other hand, market timing often involves more frequent and speculative trading trying to catch the dips.

TAA is an active investing style that incorporates passive investing and buy-and-hold qualities. You're not necessarily abandoning asset types or investments; instead, you're changing the weights or percentages to match market changes.

What Does It Mean for Individual Investors?

Those who choose to invest using TAA are looking at the big picture. They likely agree with the modern portfolio theory, which essentially states that asset allocation has a greater impact on portfolio returns and market risk than investment selection.

You don't need to be a statistician to learn how TAA works. For instance, suppose you're a fundamental investor. You've done a good job of research and analysis. Perhaps you have a portfolio of 20 stocks that have consistently matched or outperformed S&P 500 index funds three years in a row. You appear to be managing your portfolio very well.

However, you might want to consider this scenario: during a three-year period from the beginning of 1997 through the end of 1999, many people found it easy to outperform the S&P 500.

However, during the 10-year period from January 2000 through December 2009, even a solid portfolio of stocks would have had 0% return. It would have been outperformed by even the most conservative mix of stocks, bonds, and cash.

The point is that bull and bear markets can run for years, giving investors false impressions of their abilities. Because asset allocation lets you adjust the performing portion of your portfolio to match market conditions, some view it as the greatest factor in total portfolio performance over long periods.

How to Use Funds for TAA

Tactical asset allocation works well with index funds and exchange-traded funds (ETFs). Once again, the focus is mostly on asset classes and how they perform in certain market conditions. For instance, if you invest in mutual funds, you can choose stock index funds, bond index funds, and money market funds instead of building a portfolio of individual securities. The specific fund types and stock categories can also be simple, such as large-cap stock, foreign stock, small-cap stock, or sector funds and ETFs.

If you choose sectors for your TAA strategy, you might select sectors that you believe will perform well in the near and intermediate term. For instance, you may feel that real estate, health, and utilities may have the best returns over the coming years, so you may buy ETFs within those sectors.

Here is an example portfolio that uses index funds and ETFs.

65% Stocks

• 25%: S&P 500 index
• 15%: Foreign stock (MSCI) index
• 10%: Russell 2000 index
• 5%: Technology sector ETF
• 5%: Health sector ETF
• 5%: Utilities sector ETF

30% Bonds

• 10%: Short-term bond index
• 10%: Treasury inflation-protected (TIPS) bond index
• 10%: Intermediate-term bond Index

5% Cash

• 5%: Money market fund

To change weights, using TAA, you would increase or decrease percentages in certain areas to reflect your expectations of the near-term conditions. You could also choose to change other sectors, such as energy (natural resources) and precious metals.