The Fix The Investments Series

After deciding that passive investing is a more superior approach than active management, one of the most important decisions an investor can make is how to initially establish an asset allocation strategy.

Initially establishing an asset allocation strategy, a goal-based, risk management first approach to investing, depends on the proper weighting of asset classes (stocks, bonds, cash, alternatives) and the weighting of sub-classes (i.e., small and large equities, domestic and global equities, corporate and government bonds, real estate and precious metals, and so forth). 

Of course, these decisions are based on your overall objectives-based investing goals, and factors such as your ability to accumulate assets, your time horizon (some future time when you want to fully realize your goal), your tax situation, and your ability and willingness to accept risk.

As time goes on, you will monitor your portfolio and your progress, revisiting your allocation model and making necessary changes to the asset weightings as your life and goals change. Changes in the financial markets will impact strategic decisions, so asst allocation is not a one and done event. It’s an ongoing strategy that will drive your overall portfolio management process.

There are many ways to skin the allocation cat, but we’re going to take a glimpse at the two most common allocation approaches that investors use: strategic allocation and tactical allocation.

Strategic Asset Allocation

Strategic allocation is the easiest form of allocation to understand and employ. It’s about setting asset weighting targets and sticking to them.

Let’s say your financial goals dictate that setting an initial weighting of 60% equities and 40% fixed income instruments fits your risk appetite. As markets move, you will see those percentages change on their own. For instance, if equities have run the table and bonds have lagged, you may see a weighting of 66/34 that has developed as a result. Stocks gained value, bonds lost.

The goal of asset allocation is managing portfolio risk,

not trying to beat the market by taking excess risk.

A strategic allocation approach will have you rebalance back to your base strategy, the original 60/40 mix. By rebalancing back to your baseline, you will necessarily take the profits from your equities and plow those profits into the lagging bond piece. So let’s review what happened here.

  • You made money in stocks, so you take the profit, the amount above your original allocation of 60%. You sell off that 6% piece to raise cash.
  • Your 60% equity position is reestablished, thus maintaining your risk-based allocation model.
  • You lost money in bonds, so you took the cash from your stock profits to get your bond piece back up to the original 40% position, thus maintaining your risk-based allocation model. 
  • You maintained your original risk profile by reestablishing the appropriate 60/40 mix.
  • In other words, you took profits from the winning position, and plowed it into the losing position.
  • You were able to BE the market.

The primary goal of asset allocation is managing portfolio risk, not trying to beat the market by taking excess risk. Every portfolio has an optimal mix based on the level of risk you are willing and able to take. This is a very basic explanation of the strategy, but even when multiple asset classes and sub-asset classes are used, the basic concept of fixed weightings remains. 

Most importantly, this rebalancing should happen at scheduled intervals, say quarterly, semi-annually or annually. 

Tactical Asset Allocation

This is a different animal. This is where smaller decisions of timing and security selection, and the availability to timely information are critical. In other words, you are trying to outsmart the markets at given points in time, and your emphasis starts to change from risk management to seeking higher alphas, or outsized returns.

Tactical allocation is a valid approach to allocation, but not for most investors because of the higher risk exposure and the possibility of loss. This is not a BE the market strategy. It is opportunistic, and seeks to exploit current situations for the purpose of earning excess alpha, in other words, trying to beat the market.

Face it, you will never be smarter than the street, you will never have access to information before the Street, and you will never consistently be that lucky to beat the Street with tactical allocation. So, where do you begin?

There are several different allocation strategies and all have their relative value, but in keeping with our passive make-active keep philosophy, we enthusiastically puts our stamp of approval on a wealth building and wealth keeping strategy that employs strategic allocation using exchange traded funds as the preferred funding vehicle.

Be Strategic. Be the market!


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