What's the Difference Between Strategic and Tactical Asset Allocation?
The terms strategic and tactical asset allocation are bandied about, sometimes interchangeably -- which is wrong. But these investment strategies are different, and research shows that there are distinct outcomes from tactical versus strategic asset allocation.
Whether you are a do-it-yourself investor or use a financial advisor, understanding the difference between these distinct asset allocation approaches, along with their historical records of success, will make you a better steward of your money.
[See: 9 Tips to FIRE: Financial Independence, Retire Early.]
For investors, the asset allocation decision is known to explain the vast majority of investment returns, with security selection and market timing lending a smaller impact.
Although there's continuing controversy on the topic, many experts agree on the superiority of strategic asset allocation.
What is asset allocation for investors? Asset allocation explains how you divide your money into various categories, such as stocks, bonds, and cash. The reason for asset allocation is simple -- when one asset falls in value, you'll have another to prop up your investment portfolio returns. Your personal asset allocation decision depends on your risk tolerance and time horizon. Younger, more risk tolerant investors hold greater percentages of stock assets.
The classic asset allocation decision suggests a mix of 60 percent stock and 40 percent bonds. Within the broad categories, there are subcategories of stock, bond and even alternative asset classes in play.
"The difference between 'strategic' and 'tactical' asset allocations is generally one of timing," says Derek Fossier, director of investments at Equitas Capital Advisors in New Orleans. Strategic allocations to various asset classes set the long-run target. To keep on track, investors periodically rebalance back to the initial mix. Tactical allocations are generally implemented based on current market conditions and are adjusted periodically.
For example, if a recession is expected, a tactical asset allocator might sell stocks and increase a cash or fixed investment allotment, buy selling stocks and buying bonds. This tactical approach is an effort to protect stock investments from a future predicted loss in value.
Strategic asset allocation is for the long view. Dennis Baish, senior investment analyst at Fort Pitt Capital Group in Pittsburgh, says that you expect to have your strategic asset allocation target in place for a long time -- possibly until your risk tolerance levels change. An investor on the cusp of retirement might have a portfolio with a 50-50 mix of stocks and bonds and rebalance it periodically. Whereas a 35-year-old investor would create a strategic asset allocation with greater growth potential, such as 80 percent stock and 20 percent bonds.
"The driving beliefs of strategic asset allocation are 'reversion to the mean' and limiting tax and friction (trading) costs, with the idea that the allocation decisions themselves will be the primary sources of return," says Scott Welch, chief investment officer of Dynasty Financial Partners in New York.
[Read: 4 Steps to Get Over Investor Paralysis.]
Tactical asset allocation is driven by market events. In contrast, tactical asset allocation is an active investment approach that attempts to capture superior returns due to predicted underlying shifts in market fundamentals, opportunities or risks, Welch says.
Despite pros and cons for both strategic and tactical asset allocation, the latter is the most difficult. With tactical asset allocation you must get several things right; when to move into a tactical asset allocation, and when to readjust out of it. "Add in that you must be right enough to cover taxes and trading costs. It's an approach that is difficult to do well consistently," Welch says.
With tactical asset allocation, you need to predict the future with accuracy and then act on your expectations at just the right time.
Tactical asset allocation sounds tricky, because it is.
"I feel that tactical asset allocation is a form of market timing," says Rich Winer, associate vice president and wealth advisor at Steel Peak Wealth Management in Woodland Hills, California. "In my 24 years as a financial advisor, I have never come across anyone who could time the market effectively and profitably with any consistency."
Another problem with tactical asset allocation rests with picking an actively managed mutual fund or hedge fund manager. It's nearly impossible to show that a manager has skill and that any outperformance isn't just the result of luck, says Jeffrey Stoffer, owner and financial advisor at Stoffer Wealth Advisors in San Rafael, California.
[See: 16 Questions That Scare Investors, But Shouldn't.]
Yet, not all advisors eschew tactical asset allocation. Scott Bishop, partner and executive vice president at STA Wealth Management in Houston, adds a tactical overlay onto their client's strategic portfolios. For clients with a lower risk tolerance or those in retirement, Bishop attempts to circumvent market declines through a tactical asset allocation approach.
Dave Chapman, head of multi-asset portfolio management for Chicago-based Legal & General Investment Management America sums up the strategic versus tactical asset allocation decision: "For the vast majority of individuals, tactical asset allocation is fraught with risks including the risk of losing capital, exposure to higher volatility, regret and other behavioral factors that can compound these issues."
More From US News & World Report
