Written by Stephen Ostrofsky, CFP®
For the year 2018, the Dow Jones Industrial Average and Russell 2000 Indexes were down 3.48% and 11.01%, respectively. During the year while the Federal Reserve, raised interest rates, the overall bond market was down slightly. So what are investors to do now? That depends on what your investment policy statement, which details your investment portfolio asset allocation and how it is to be adjusted over time. There is little debate amongst financial pundits about the benefits of asset allocation models when constructing and managing an investor’s investment portfolio over time. This type of approach utilizes an investment policy statement to govern the decision-making process for the allocation of investment funds according to, amongst other factors, an investor’s risk tolerance and investment time horizon. As financial theory asserts, investors will be able to establish the optimal mix of asset classes to maximize their investment returns for a given level of investment risk. The current debate concerns the differences between strategic and tactical asset allocation models. Let’s begin with a brief discussion about these two methods of portfolio construction and management.
Strategic asset allocation describes the process of portfolio construction and management through the establishment of an optimal mix of investments across all asset classes (i.e., large cap value, emerging market debt or corporate bonds). The primary engine for this strategy requires that the optimal asset allocation remain relatively stable over the long term through periodic rebalancing towards target allocations. The benefits derived from rebalancing include more constant level of risk for the overall portfolio while the rebalancing transactions that result in “selling high” a portion of an asset classes that has appreciated and “buying low” into an asset class that has lagged behind. Strategic asset allocation strategies are sometimes confused with “buy-and-hold” investing. This is inaccurate because with a “buy-and-hold” strategy, price fluctuations would not trigger any transactions whereas with strategic asset allocation, transactions are triggered as a result of securities price changes during up or down markets.
Tactical asset allocation describes the process of portfolio construction and management begins with the establishment of a strategic, long term target mix of investments across all asset classes. The difference with that tactical asset allocation approach is it provides for a range of investment percentages for each asset class detailed in the investment policy statement. Within each asset class, an investment advisor evaluates the current economic and market conditions to determine how much to allocate towards each asset class within the acceptable ranges. Both investment strategies will tend to outperform an “average investor” who tends to underperform market indexes due to emotional, irrational decision-making.
While a strategic asset allocation strategy seems simplistic and robotic, a tactical asset allocation strategy requires accurate forecasts and timing. Strategic asset allocation strategies can produce predictable investment returns over the long run. For investors who face changes in their investment time horizon, such as retirement, a tactical asset allocation strategy will take into consideration the current economic and market conditions when selecting your specific investment allocations. Working with an investment advisor to implement a tactical asset allocation strategy will have greater costs associated with the advice. What strategy will yield better results depends on an individual investor’s personal situation and needs.
Past performance may not be indicative of future result. Investment decisions must be made on your own individual needs and risk tolerance.
Asset allocation and diversification cannot guarantee profit or insure against a loss. There is no guarantee that any investment strategy will be successful; all investing involves risk, including the possible loss of principal.
