How to Use Tactical Asset Allocation to Beat the Market

Follow macro economic signals and profit from changing market dynamics

There are so many schools of investment management that it can be tough for people to decide among them. For instance, there’s the one camp that advises a simple approach — strategic asset allocation. With strategic asset allocation, the investor chooses an asset mix that fits with her goals, risk level and financial assets. This strategic asset allocation remains constant until a life change causes the investor to adjust.

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Meanwhile, tactical asset allocation purports that you can improve upon market returns with periodic changes in your asst mix percentages based upon factors like the economy or business environment.

Tactical asset allocators believe that by choosing the best asset allocation you can achieve greater returns than with a stock picking approach or a strategic model.

What is Tactical Asset Allocation?

In contrast with strategic, the tactical asset allocation strategy is a more active investment management approach. Investors who favor a tactical approach will change the percentages allocated to various investment classes depending upon macroeconomic factors. Those factors might include the expected performance of certain market sectors or a global economic outlook.

With strategic asset allocation, an older investor might select a 60% stock, 30% bond and 10% cash asset allocation. When one asset class becomes over- or under-weighted the investor buys or sells the appropriate assets in order to return the portfolio to the original 60% stock, 30% bond, 10% cash positions.

With tactical asset allocation, the investor picks target weights for asset classes based upon shorter-term factors.

For example, after a market crash, when investment values become discounted, you might boost your asset weight in equities from 60% to 70% due to the research that favors outperformance of undervalued asset classes.

Then as equities grow and become overvalued, you might reduce exposure to 50% or 40% equities, until valuations substantially increase.

Tactical asset allocation can also be used within an asset class to target specific market sectors.

For example, the hospitality sector is currently quite depressed due to Covid-19 and the reality that fewer people are traveling. A tactical asset allocator might decide to invest in a sector fund that includes companies in the leisure and hospitality industry with the expectation that when travel and leisure activities increase, so will the performance of the leisure sector investments.

How to Implement Tactical Asset Allocation

When diving into tactical asset allocation, understand that there’s not one specific way to implement this approach. The following are guidelines you can use to improve your returns with tactical asset allocation.

First, increase your knowledge and awareness of business and economic factors that ultimately might move markets.

Then decide on a percentage of your portfolio that you will shift between asset classes. Typical amounts are between 5% and 15% of the portfolio. In the beginning, smaller shifts might be more appropriate.

Next, consider the economy, investment markets and other economic factors. On a macroeconomic level, determine the current relative risk in the market. This can be done by examining valuation levels of riskier assets versus the norm, or other broad economic factors like unemployment levels and the yield curve.

For example, when the average Shiller price-earnings ratio is higher, subsequent equity market returns are lower. The Shiller P/E divides the current market price by the average prior 10 years market earnings. Presently, the current Shiller P/E is approximately 30 while the average is 16.72. The tactical asset allocator might use this information to determine that the market is overvalued and is more likely to fall than rise.

In this case, you would reduce the equity allocation.

The only problem with this approach is that in reducing the equity allocation, you might miss out on future upside returns, as markets can stay overvalued for long periods of time before reverting-to-the-mean.

Here’s another example of how to implement tactical asset allocation in your portfolio. In many instances when the yield curve is inverted, a recession follows. An inverted yield curve means that shorter term interest rates are higher than long term rates.

Typically, during a recession, stock market prices fall.

A tactical asset allocator might reduce stock market percentages and increase bond holdings in this case, to preserve principal.

Then should the recession ensue, and stock prices fall, you might boost your stock market exposure, buying a broad market index or individual sectors on sale. When economic conditions begin to turn around and asset prices rise, you’ll benefit from the capital appreciation.

Tactical Asset Allocation Wrap Up

Using a basic stable of exchange-traded funds makes it easy to implement a tactical asset allocation strategy. There are many sector ETFs, as well as diverse country and international stock and bond ETFs. Other ways to attempt to improve on market returns is by investing in smart beta strategies and actively managed mutual funds.

Finally, tactical asset allocation might just beat the returns of a strategic asset allocation approach. With attention to trends and minor adjustments to your portfolio, there’s an opportunity to profit.

Barbara A. Friedberg, MBA, MS is a veteran portfolio manager, expert investor, and former university finance instructor. She is editor/author of Personal Finance; An Encyclopedia of Modern Money Management and two additional money books. She is CEO of Robo-Advisor, a robo-advisor review and information website. Additionally, Friedberg is publisher of the well-regarded investment website Barbara Friedberg Personal Follow her on twitter @barbfriedberg and @roboadvisorpros. As of this writing, she did not hold a position in any of the aforementioned securities.

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