If you have read enough portfolio
publications and books, you may have came across this term called “tactical
asset allocation”. According to Investopedia, tactical asset allocation is “an active management portfolio strategy that
shifts the percentage of assets held in various categories to take advantage of
market pricing anomalies or strong market sectors”.1 In other
words, your portfolio’s asset class allocation will change according to the
prevailing environmental factors and economic conditions.
Taking the balanced Bedokian Portfolio for
example (35% equities, 35% REITs, 20% bonds, 5% commodities and 5% cash), if
the market is pointing to a boom period where equities and REITs are likely to
gain, and in order to capture their rise, you would adjust your portfolio to
40% equities and 40% REITs, while reducing the bond component from 20% to 10%.
Then with recession looming, you would increase your bond holdings to 30%, and
reduce equities and REITs to 30% each, since bonds perform better in such times.
Besides asset classes, tactical asset
allocation can also be done on a sector/industry level. During recession times,
defensive sectors/industries such as utilities and consumer staples fare better
than others, so more allocation is given to them. Sometimes asset class and
sector/industry tactical asset allocation can be done together. All these are
done in an attempt to maximize returns given the situation. Since the tactical
asset allocation is done based on the economic cycle, this investment style is
also known as economic cycle investing.
The Economic Cycle
The economic cycle, or sometimes referred
to as the business cycle, is “the natural
fluctuation of the economy between periods of expansion (growth) and
contraction (recession)”.2 There are various sub-stages within
this broad view of expansion and recession, and the typically accepted stages
are expansion, peak, recession and trough (see Fig. 1).
Fig.
1 – The economic cycle
About Strategic Asset Allocation
Let me share a bit about strategic asset
allocation, where it is “a portfolio
strategy that involves setting target allocations for various asset classes,
and periodically rebalancing the portfolio back to the original allocations
when they deviate significantly from the initial settings due to differing
returns from various assets”.3
This means come rain or shine, the portfolio asset class allocation
remains the same. The Bedokian Portfolio is a form of strategic asset
allocation, and rebalancing back to your preferred asset class allocation
periodically is part and parcel of the overall strategy.
The Bedokian’s Take
Portfolios using tactical asset allocation
have their merits on the theoretical assumption of having more returns in a
given economic cycle condition than strategic asset allocation, since the asset
class/sector/industry that perform well at that moment is given more weightage
to capture the returns as compared to strategic asset allocation ones. However,
from the perspective of The Bedokian Portfolio, whether you are an active or
passive investor, it is better to stick to its original form.
It is hard for any investor to predict the
direction and behaviour of the markets and economy, let alone know at which
point the economic cycle is at, even with ready information on hand. Fig. 1 is
a perfect example on how the economic cycle looks like, but in the real world
this may not seem so. The expansion could be longer or shorter than the
recession phase, and sometimes what is deemed to be down (or up) could quickly
reverse to go up (or down). In this case, it is better to be more reactive and
less proactive.
Even if you are able to guess the movements
of the markets, the constant rebalancing of your asset classes and
sectors/industries would incur more transaction costs than even a normal active
Bedokian Portfolio investor, and this in turn means lesser returns.
However, I am not totally against tactical
asset allocation, just try not to use it on your Bedokian Portfolio. Remember,
the main aim of it is “passive income through dividend and index investing”. If
your capital allows, you could have another portfolio that uses the tactical
way, which is good for a topic of discussion for another day.
