Tactical asset allocation: An active approach to portfolio management

Tactical asset allocation (TAA) is an active investment strategy that allows for short- to medium-term deviations from a long-term strategic asset allocation to capitalize on market opportunities or manage risk. Essentially, TAA involves temporarily adjusting the weights of different asset classes in a portfolio — like stocks, bonds, or cash — to react to current market conditions, economic trends, or technical indicators while still returning to a long-term target allocation over time.

TAA is an active management strategy, calling for investors or portfolio managers to make decisions based on market outlooks to try to “overweight” or “underweight” certain assets. While TAA involves more frequent shifts in asset class weights, they are not meant to be permanent, but rather to respond to perceived opportunities or risks.

In general, TAA may be divided into two main classes: discretionary or systematic. Understanding the differences between these strategies while taking your personal preferences into account can help you better choose what method works best for you.

The discretionary tactical asset allocation strategy is based on human judgment and active decision-making in your portfolio processes. This method uses portfolio managers or investors to analyze macroeconomic data, market trends, news, and overall experience to manually make shifts in your portfolio in response to perceived opportunities or risk. A fund manager, for example, might move certain stocks around if they anticipate regulatory changes, allocating them to favor these changes.

Discretionary TAA is flexible and responsive and can incorporate qualitative factors and expert insight, but consequently, it may also be subject to emotional bias and decision errors and can be heavily reliant on the manager’s skills and timing response to live events.

Systematic, or quantitative, tactical asset allocation, on the other hand, works using rules-based models or algorithms. This tactical asset allocation approach uses quantitative data, such as price momentum, volatility, interest rates, and economic indicators, to make automatic adjustments based on predefined conditions. For instance, a model may increase exposure to equities when market momentum is positive or decrease when volatility surpasses a certain threshold.

Unlike discretionary TAA, systematic TAA reduces the emotional bias when shifting assets and is also backtested and consistent in application. However, because it is a quantitative approach, it also risks potentially missing out on qualitative insights, and may also be less flexible when adapting to unexpected occurrences or black swan events (a rare, unpredictable event that significantly, often negatively, impacts financial markets).

To get a full understanding of the tactical asset allocation strategy, we can compare the differences from a longer-term, more passive investment approach, strategic asset allocation (SAA). 

The SAA method involves setting target allocations for your asset classes — for example, 70% stocks and 30% bonds — which are designed to remain stable and only periodically adjusted. Adjustments are made by rebalancing your portfolio depending on how your assets have grown or decreased. If the stock portion of a portfolio goes up to 80% after a robust year, then it would be rebalanced by selling some of the stocks and using that to buy more bonds, to bring the assets back to their default parameters. 

While TAA also involves choosing target asset allocations when establishing your portfolio, the key difference is that you may temporarily change those allocations in response to market factors or opportunities. After you are satisfied with the short-term returns, or the momentum from a particular stock or other asset settles down, you would shift your assets back to meet your baseline allocation.

TAA therefore gives you more flexibility to ride market fluctuations when a particular stock or sector rises, allowing you to stray from your original asset allocation baseline — temporarily at least. SAA, on the other hand, places greater emphasis on ensuring your portfolio is meeting its target asset allocation, therefore, a skyrocketing stock would not be as important.

To put things into a clearer perspective, let’s consider a theoretical example of tactical asset allocation. 

Jamie is a moderately aggressive investor with a $250,000 portfolio and a baseline of: 

• 60% stocks — $150,000 

• 30% bonds — $75,000 

• 10% cash — $25,000 

Jamie’s portfolio manager believes that the technology sector will outperform over the next 6 – 12 months due to strong earnings reports and increased consumer demand. Concurrently, rising interest rates may hurt bond performance. 

To take advantage of this opportunity, Jamie temporarily shifts her asset allocation to the following: 

• 70% stocks — $175,000

• 20% bonds — $50,000 

• 10% cash — $25,000

Nine months later, Jamie and her manager review the market once again and notice that while tech stocks have indeed performed well, they are starting to cool off. She decides to revert to her original 60/30/10 allocation by selling some tech equities, reinvesting in a diversified bond ETF, and maintaining a long-term balance in a high-yield savings account. 

This is a classical tactical move because Jamie temporarily shifted from her long-term strategy based on a short- to mid-term market outlook and later rebalanced back to the baseline allocation. While it would be ideal to know what the best tactical asset allocation models are, this is easier said than done. Since everyone has their own unique financial situation, investment goals, and risk tolerance, the best TAA strategy would be the one that best fits your goals and needs. 

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Like with most investment strategies, it is also important to consider the pros and cons of TAA. Weighing the potential benefits and drawbacks can help you better decide if this is the right asset allocation strategy for you.

Some of the potential benefits of utilizing a TAA strategy include: 

• Flexibility and agility: TAA allows you to quickly rebalance your portfolio in reaction to market events. Shifts in inflation and interest rates, stocks, and economic events can influence market trends and allow you to temporarily shift your assets in response to these conditions. 

• Potential for higher returns: TAA allows investors to take advantage of short- to mid-term market trends, which can potentially outperform static asset allocation strategies.

• Risk management opportunity: Investors can help protect their portfolios during downturns by reducing exposure to asset classes that may underperform.

However, TAA may also have potential drawbacks, including: 

• Market timing skills: Successful TAA strategies require accurately predicting market movements, which may be difficult even for the most seasoned professionals. 

• Time-intensive and complex: TAA is quite demanding in terms of the active monitoring of market trends, economic indicators, and news, making it more hands-on than passive investing.

• Emotional investment risk: Tactical shifts can be influenced by fear or greed, potentially clouding your judgment and leading to poorly timed decisions or overreactions to market noise.

If you are looking for a more hands-on, active management investment approach, tactical asset allocation might be what you’re looking for. However, like with most financial decisions, it is crucial to consider the benefits and potential drawbacks you might face when choosing a TAA strategy. Investors should also keep their risk tolerance, financial situation, and investment horizon in mind when choosing what approach best fits their investment goals. 

If you are still undecided with what strategy is best for you or simply want to diversify your portfolio, Raisin is here to help. The Raisin marketplace gives you access to a variety of high-yield savings products with competitive interest rates, allowing you to diversify your cash savings and make the most of your money. Sign up today and start growing your wealth!

The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.