Before creating a portfolio, you need an asset allocation strategy. Specifically, you need to know whether to allocate your assets in a strategic, dynamic, or tactical method. All methods can move your portfolio toward the ultimate goal of diversification. But your financial goals, investment skill, personal risk appetite and aggressiveness in seeking rewards will inevitably push you toward one asset allocation model over the other. Once you understand the differences between the dynamic, strategic, and tactical asset allocation paradigms you can properly implement an optimal mix of assets in your portfolio.
Contents
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Summary
- Strategic asset allocation sets static benchmarks for each asset class based on an investor’s risk profile and long-term financial goals. The portfolio is periodically rebalanced to maintain the strategic asset allocation. Strategic is the most passive type of asset allocation.
- Tactical asset allocation makes short-term adjustments to the asset mix based on the current risk/return profiles of each asset class, given the current market conditions.
- Dynamic asset allocation yields a constantly changing asset mix based upon changing market and individual asset factors. This is the most active type of asset allocation among the tactical vs strategic investing.
Strategic vs. Tactical vs. Dynamic Asset Allocation – What’s the Difference?
Timing is the most salient differentiator among these allocation methodologies. That is, both investment horizon and your frequency of rebalancing will push you toward a specific strategy. We will review the general heuristics for each allocation type, but first understand the asset allocation concept and its importance.
What is Asset Allocation?
Asset allocation is a means of reducing portfolio risk and possibly increasing the expected return over time. Specifically, asset allocation is your division of capital into different asset categories – traditionally stocks, bonds, and cash. Your risk tolerance and investment time horizon come into play, as they influence the proportion of capital you dedicate to each category.
For example, an investor with a low risk tolerance and shorter time horizon, such as a person planning to retire in the next few years, will likely put a greater amount of capital into cash and bonds to minimize the risk of a stock-heavy portfolio. More aggressive, younger investors with long investment horizons will allocate more capital to stocks and stock funds. The growth potential and risk is higher with stock assets, and – even though that growth comes at the price of increased risk – aggressive investors with long-term investment horizons can weather a short-term pullback in their portfolios.
Why does Asset Allocation Matter?
Why is asset allocation important?
Asset allocation doesn’t just matter – it’s one of the most important decisions an investor can make! Not only does it determine the expected growth of your portfolio, but it also determines the proportion of your capital that can disappear in an unfavorable market situation-like a stock market crash. That is, asset allocation allows you to estimate and control both your maximum loss and control your portfolio’s general growth rate, thereby letting you hit your financial goals.
Of course, all growth and loss projections are based upon historical returns, as the perfect crystal ball hasn’t been invented yet. This means there’s no perfect assurance that your projections will pan out.
An important difference between a successful investor and an unsuccessful one is that the successful investor tends to focus on asset allocation, while unsuccessful investors tend to focus on the assets themselves. Arguably, the average investor spends way too much time comparing individual stocks or bonds and not enough time deciding exactly how much capital to invest in said stocks or bonds. An investor who evaluates her financial goals and risk tolerance will, be better off than an investor who focuses on the nuances between two individual publicly traded companies.
By learning of the different types of asset allocation methods, you’ll be one step ahead of the majority of your peers.
What is Strategic Asset Allocation?
Strategic asset allocation, in contrast with dynamic asset allocation, focuses on longer-term financial goals, and the investors risk tolerance. This is the most common type of asset allocation. For a portfolio employing this asset allocation strategy, 90% of returns come from long-term positions according to Vanguard research. The strategic approach places a set proportion of your capital into each asset category. That proportion remains the same, as long as your financial goals and risk tolerance endure.
With strategic asset allocation, when the desired asset class proportions deviate from the desired percentages, the portfolio is rebalanced back to the strategic asset mix.
With a 60% stock, 40% bond portfolio, if your stocks do exceptionally well, your portfolio could become a 70%/30% stock/bond split over time. Adhering to the strategic asset allocation design, you would sell down your stocks to 60%, while buying bonds with the proceeds to rebalance your portfolio back to a 60%/40% split.
Who is Strategic Asset Allocation Best For?
The strategic asset allocation plan works especially well for investors who want to avoid making decisions based on emotions. It also works well for those who don’t want to continually change their portfolio based on market conditions, instead sticking with a single, easy-to-follow, long-term plan. Strategic asset allocation investors might not experience the strong returns that come with more active investing, but they also can avoid large losses.
What is Tactical Asset Allocation?
Tactical asset allocation is the next variation of Strategic Asset Allocation. A baseline asset allocation is created, much like that of the Strategic Asset Allocation. But tactical asset allocation considers short-term economic or market trends. Using this information, a temporary shift from the baseline asset allocation is adjusted. When conditions warrant, the portfolio will return to its pre-determined asset mix.
For example, an investor with a 70% stock, 30% fixed portfolio who believes stocks are overvalued and expects a near term stock market crash might shift their asset allocation to 60% stock, 40% fixed to minimize future losses, should the stock market crash.
Once the crash is over, the investor will return to the 70% stock/30% fixed mix.
Investors using this method of asset allocation are looking for temporary inefficiencies in the market, such as stocks being overbought or overpriced, and capitalizing on those ephemeral market features.
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Who is Tactical Asset Allocation Best For?
Those who have an understanding of the economy and market movements might consider tactical vs strategic asset allocation. For example, when bond yields are relatively high and a rate decline is predicted, investors might shift some of their fixed assets into longer term bonds. When interest rates decline, bonds tend to appreciate, with longer term issues increasing more than short term bonds.
After a stock market crash, savvy tactical asset allocators might load up on stocks, purchased at bargain prices.
Predicting market movements always includes the risk that your prediction will be early or wrong.
What is Dynamic Asset Allocation?
The dynamic asset allocation investment strategy involves frequent adjusting of asset weights and investment categories, based on market conditions and investment theories. This asset allocation strategy is flexible and requires the investor to have the skill and time to engage in research and act on the findings.
Dynamic Asset allocation not only shifts portfolio weights between stocks, bonds and cash, but will delve into specific securities, and narrow asset classes. For example, an investor might perceive Japanese stocks to be overvalued, and load up on those securities. Or she might pile into healthcare stocks when the sector exhibits momentum.
The most notable benefit of the dynamic approach to asset allocation is the potential for higher average returns due to the ability to reallocate capital in response to a changing market. This allows investors to reduce risk when the market is looking weak and increase returns when the market is showing upward momentum. While potential returns are greater with dynamic asset allocation vs strategic and tactical asset allocation, the risks for error are also greater.
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Who is Dynamic Asset Allocation Best For?
A portfolio managed via dynamic asset allocation requires the manager or investor to keep an eye on the market and react to changing market conditions. Only sophisticated and professional investors should attempt the frequent trading required by dynamic asset allocation.
A dynamic approach requires active involvement in portfolio management and will incur more taxable events than strategic asset allocation.
The same caution that we mentioned in the tactical asset allocation, holds true with dynamic asset allocation. Too many transactions in the wrong direction can result underperforming a strategic asset allocation.
Which Type of Asset Allocation is Best for You?
Your attitude toward risk, and your skill as an active investor will influence the best asset allocation model for you. In addition, your investing experience and research tools can play a part; successful tactical and dynamic asset allocation require more investment experience and a larger research toolbox. Other factors that are at play include your current assets as well as liabilities, financial goals, and tax situation.
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