Tactical asset allocation, also known as portfolio construction, is an investment strategy that actively adjusts an investor’s asset allocation in response to changing market conditions. The key objective of a TAA plan is to increase the average risk-adjusted return of passive portfolio investing.
It’s very important that you have a good understanding of asset allocation and different asset allocation strategies when managing your portfolio to help you take advantage of changing market situations.
As a new investor, you will likely focus more on the most profitable stocks or bonds to include in your portfolio; however, if you want to take advantage of the ever-changing asset value. In that case, experts recommend that you build your portfolio around asset classes instead of focusing on an individual stock or fund.
Just in the same way a roadside vendor often sells seemingly unrelated products, you should learn to include different asset classes in your portfolio so that you can easily make adjustments to keep up with the market trends. Continue to read below for all you need to know tactical asset allocation and how you can use it to your advantage.
What Is Tactical Asset Allocation
Tactical Asset allocation, also known as TAA, is a portfolio management strategy that focuses on actively adjusting and balancing the three primary asset classes (Stock, bond, and cash) to take advantage of changing market trends.
For starters, assets go through a bull and bear market; instead of just focusing on specific asset choices, you can choose to keep an ideal mix of different asset types to fit your desired risk level. The goal is to diversify your asset in a way that balances risks and rewards so you can take advantage of different asset classes at the same time.
TAA is quite different from strategic asset allocation, which is based on set targets. Strategic asset allocation is a long-term portfolio management approach focused on establishing an ideal asset mix according to the expected return rates.
With a strategic asset allocation strategy, you don’t have to change your asset allocation regularly based on market conditions; rather, you add money regularly and only rebalance your asset allocation on an annual basis. TAA, on the other hand, is a more flexible, short-term asset allocation approach that allows you to adjust your asset allocation based on market trends.
How Does Tactical Asset Allocation Work?
People have different investment goals as well as different risk tolerance levels. As an investor, you can adopt a tactical asset allocation strategy if you want to have a portfolio that is in line with your goals and risk tolerance level.
For this strategy to be effective, you need to have the ability to spot market trends and how asset classes move in response to different market changes to shift your asset allocation accordingly to your advantage.
For a beginner’s portfolio, your asset mix might contain:
- 60% of stocks
- 35% of bonds
- 5% cash
This asset allocation is considered tactical because you can regularly adjust the percentages of allocations based on the current or expected economic fluctuations.
If, for instance, you discover that stocks are becoming expensive and you fear that there might soon be a bear market, you can rebalance the asset mix by reducing your allocation to stocks so that you escape the market risks. Your asset allocation mix may now be:
- 50% of stocks
- 40% of bonds
- 10% cash
With these adjustments, you have successfully underweighted stocks to reduce any risk of loss. If the bear market progresses and you notice an opportunity in bonds, you may decide to keep increasing your allocation to bonds to help you maximize profit.
The idea of tactical asset allocation is to change your asset allocation according to the current market situation. Instead of just focusing on one particular investment, you focus on an entire class of assets at a time.
Reasons For Tactical Asset Allocation
The major reason for adopting a tactical asset allocation plan is to maximize profit and minimize losses. There are several reasons why investors use tactical asset allocation, some of which include:
- Adapting to market situations
One of the reasons many investors adopt a tactical allocation strategy is because it enables them to adapt to the ever-changing market conditions swiftly. With a TAA strategy, an investor can adjust the weights of the allocations to different asset classes based on the current market conditions.
- Increasing Portfolio Returns
Tactical asset allocation has more impact on portfolio returns than individual investment choices. Tactical asset allocation allows investors to take advantage of opportunities when they arise by increasing allocation to the best performing asset classes. This, in turn, yields better portfolio returns.
- For Diversification
Tactical asset allocation gives room for portfolio diversification. When making investment decisions, it’s not always safe to put all your eggs in one basket. By diversifying your assets, you can minimize losses and maximize profits.
Another reason for tactical asset allocation is to mitigate a portfolio’s decline during a bear market. Once an investor senses an upcoming bear market for a particular asset class, he can take steps away from the risks by reducing the allocation to that asset class and increasing his allocation to other promising asset classes within his portfolio.
Types of Tactical Asset Allocations with Examples.
Tactical asset allocation can be used to adjust asset classes in a portfolio. It can also be used to adjust allocations within an asset class.
- Tactical Asset Allocation Within A Portfolio
This involves shifting asset classes within a portfolio. For example, Mr. Mark told his portfolio manager that he wants his asset allocation to include 69% stocks, 35% bonds, and 5% cash. However, his portfolio manager informs him that there is an indication of potential poor stock returns, and to minimize losses, he should readjust his asset allocation.
Using the tactical asset allocation strategy, Mr. Mark can shift the asset classes in his portfolio from
- 60% stocks
- 35% bonds
- 5% cash
- 25% stock
- 65% bonds
- 10% cash
- Tactical Asset Allocation Within An Asset Class
It is also possible to use tactical asset allocation to make changes within an asset class. Each asset class has sub-categories, and you can use TAA to change the allocation within these categories.
From our first example, Mr. Mark now has an asset allocation of 25% stocks, 65% bonds, and 20% cash. Tactical asset allocation can be used to adjust the allocation within each asset class as follows.
Within 25%stock allocation
- 25% large-cap domestic stocks
- 45% medium-cap domestic stocks
- 10% small-cap domestic stocks
- 5% micro-cap stocks
- 15% foreign stocks
Within 65% bonds allocation
- 25% treasury bonds
- 55% investment-grade bonds
- 20% non-investment grade bonds
Within 10% cash
- 100% cash
One of the keys to success in investments is paying attention to market trends and acting swiftly to ensure that the odds are in your favor. It’s always better to diversify your asset allocations. When you invest solely in one asset class, you increase your portfolio risk. The stock market crisis in 2000 and 2008 should be enough to convince any investor of the Importance of diversification.
TAA works best for those with the ability to spot market trends and understand how different assets relate to each other. With the right application, TAA can help you rebalance your portfolio in such a way that it enables you to maximize profits and minimize losses.
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