Tactical versus Strategic Asset Allocations (Explained)

Over the last 5+ years, Strategic Asset Allocations have generally outperformed Tactical Asset Allocations. This observation is not unique to Friedenthal Financial. Across the investment industry, buy-and-hold (and rebalance) portfolios have outperformed their active alternatives by a considerable amount. Here at Friedenthal Financial, we have seen many clients shift from Tactical to Strategic allocations for this reason. Any time that a client or prospect asks about the difference between Tactical and Strategic Asset Allocations, we give a long-winded answer that includes lots of pros and cons because, well, one is not BETTER than the other. Let me explain…

Strategic Asset Allocation is designed to be extremely well diversified, tax efficient, and tailored to a specific Risk Tolerance (defined as a ratio of stock/bonds). After the initial investment is executed, the maintenance of the portfolio includes investing new cash from dividends and interest paid by the funds, raising cash for client withdrawals, and rebalancing the account back to the target portfolio weights as needed. If the stock market goes up or down, the client should expect that the allocation to stocks in the account will go up or down in similar fashion. Likewise with the bond allocation in the portfolio. A successful Strategic Asset Allocation approach requires the discipline to stick with the constant risk level of the portfolio in both up and down markets.

• Pros: Similar magnitude of gain in an up market as Benchmark Portfolio, lower cost, tax efficient.
  
• Cons: Similar magnitude of loss in a down market as Benchmark Portfolio, not actively managed

Tactical Asset Allocation is not focused as much on diversification as Strategic. In fact, the goal is to give up a portion of the diversification to seek more concentrated exposures in specific asset classes and market sectors. In our Tactical Asset Allocation, we dynamically shift the holdings based on the shorter-term market trends. In some markets, a Tactical Asset Allocation will have lower risk than the client’s Risk Benchmark. In extreme situations, the portfolio may have 100% in fixed income securities due to high levels of volatility or negative equity market trends. Many more transactions occur in a Tactical approach, but the benefits in a Recession generally become well worth underperformance in some other market cycles. Over a long period, a Tactical approach will react to bear market signals, many of which will end up being “False Alarms”. This discipline is what gives the downside protection in the case where the Alarm turns out to be a real fire.

• Pros: Active, trend following, downside protection.
• Cons: False Alarms, Possibility of underperformance over longer periods of time, higher fees, less tax efficient
  

Combination: One approach that our clients have available is to have both Tactical AND Strategic Allocations. At the same Risk Benchmark or different, having some of both can give the benefit of minimizing regret in when one strategy does better than the other. Sort of like a hedge.

At the time of this letter, we are officially in the longest bull market in history. I am willing to make a bold prediction: There will be another bear market. Ok, not that bold. The question is not IF there will be another bear market, but WHEN and HOW DEEP. These are the million dollar questions that you shouldn’t be asking when making an Asset Allocation decision. Instead, you should ask how you expect your portfolio to perform when it happens, and what is the tradeoff. Whatever decision you make, you need to know that you can stick with either through long periods of time to avoid “performance chasing” (switching back and forth to the allocation that has recently performed better).