Strategic & Tactical Asset Allocation


Strategic Asset Allocation is the top down portfolio structure that determines how an investor will spread their assets among the various asset classes (stocks, bond, real estate, currencies and commodities). We like to think of the Strategic Asset Allocation as the foundation or anchor in the creation of a disciplined investment program. By having a target asset allocation, you can take most of the emotion out of the investment process. All you have to do is stick to the plan.

Implementing Your Strategic Asset Allocation

The traditional asset allocation process starts with getting to know your tolerance for risk and your investing timeframe. This is easier said than done, as the assessment of one’s risk tolerance is more an art than a science. Most people who say they have a high-risk tolerance often rethink that position when their portfolio is down 40 to 50%. Just ask anyone how they felt about their investment decision at the depth of the financial crisis. Most people were saying they did now know they were taking so much risk. Point “A” on the chart below shows the point risk tolerant investors choose as they are attracted to the high rate of return. But 20% portfolio volatility implies a 20% loss 16% of the time or one every 6 years. It implied a 40% annual loss 2.5% of the time or once every 40 years. This of course assumes you can do a good job of estimating your portfolio volatility.

In strategic asset allocation, the target portfolio allocations depend on a number of factors. In addition to risk tolerance, a strategic asset allocation takes into account one’s age, investment  time horizon, liquidity needs, number of dependents (children, siblings, parents) level of income, amount of savings,  taxes, investment objectives,  etc. These factors will change over time, so it is worth reviewing your situation every year or two, or when you have a life altering event (new child, illness, etc.)  Strategic asset allocation is compatible with a “buy and hold” strategy. This can be intimidating, but there are ways to keep it simple. In doing so you might not get to the exact right answer, but you might get 75% of the way there. One way to do that is to z the process and use a simple rules of thumb to help determine ones strategic asset allocation for their retirement funds. One of those rule of thumb is summarized by the following two equations.

% (Bonds + Cash) = Your Age

% (Equity + Real Estate) = 100% – % Bonds

If you are 40 years old, this suggests you should have 40% of your money in bonds and 60% in Stocks and Real Estate. The following chart should help visualize how your Strategic Asset Allocation will change over time.

We think about equity and real estate as risk assets with growth potential. We select an allocation to these investments investment to grow our wealth and hold assets that provide some inflation protection. Fixed income and cash investments are designed to preserve wealth and provide liquidity. You do not what to be forced to sell an investment that might be down in value to pay a bill. So these are assets that sit in one’s portfolios to cover unforeseen spending demands. Unlike others, we think of cash as a strategic asset. Contrary to common industry practice, we generally do not recommend being fully invested 100% of the time. We like to have some cash or short-term treasuries on had to buy an stocks, a piece of real estate, a high yield bond, etc. that is beaten down in price.  Sure you can always reallocate and sell one investment for another, but if the entire market is down, you might just e selling one cheap asset for another.

People save and invest for reasons other than retirement. New couples may be saving for a down payment on a house. Such an objective has a short time horizon. As a result, these funds should have a much heavier weight to bonds and cash than equity securities. The last thing you want to do is suffer a big loss just as you are getting ready to close on a house.

It is important to rebalance your portfolio at least once a year for reasons beyond a change in circumstances. A change in the value of asset more generally can be a reason for rebalancing. Sometimes bonds out perform equity and sometime they underperform equity. The asset class that produces the highest return will become over weighted over time. To remain in balance, one must be reduced to by selling the high returning asset class and buying the low retiring asset class. Since it is a mechanical process, rebalancing creates a discipline that puts emotions to the side. Furthermore, the discipline  naturally pushes you to sells high and buy low. That’s a good thing.

Creating Your Asset Mix

The next step in the process is to actually select the assets to put in your portfolio. One can get their equity exposure a number of ways. One can invest in large, mid and small cap stocks. Once can buy stocks in domestic companies and stock in international companies (developed market or emerging market or even frontier market.) Since the US economy makes up just 16% of the global economy, it is advisable to invest internationally as well as domestically. How much is a difficult question and is a very personal choice. But given the size of the global economy outside the US, many US investors are underweight international holdings.

How you choose your Strategic Asset Allocation and what financial instruments you use is a personal choice. The following example might be a good place to start. To be clear, this is not a solution of any particular person or family. Those are very personal decisions, and everyone’s should work that out with their financial advisor. Examples are a good way of opening issues for dialog.

Example of Strategic Asset Allocation: Equity & Real Estate

Asset Class Ticker Description Allocation
Equity SPY Large Cap US 29.0%
Equity VEA Large Cap Non-US 12.0%
Equity EEM Emerging Market 7.0%
Real Estate VNQ US REIT 16.0%
Real Estate VNQI Non-US REIT 11.0%
Equity Active 25.0%

Example of Strategic Asset Allocation: Fixed-Income & Cash

Asset Class Ticker Description Allocation
GOVT GOVT Government Bonds 12.0%
Municipal MUNI Minicipal Bonds 8.0%
MBS VMBS Mortgage Backed Securities 4.0%
LQD LQD US Corporate Bonds (IG) 14.0%
HYG HYG US Corporate Bonds (HY) 14.0%
NBDX NBDX International Bonds (IG) 14.0%
HHYX HHYX International Bonds (HY) 14.0%
Cash 20.0%

So, in this example, if you it investor is years old, has an average risk tolerance, does not have immediate liquidity needs, etc. they might want to put 60% of your assets in the Equity & Real Estate Bucket and 40% in the Fixed Income & Cash bucket.

Active versus Passive Management

There is another choice to consider, and that is active versus passive management. We show that aspect of Strategic Asset Allocation in the Equity & Real Estate bucket. This is the allocation for your stock picking and options trades. Notice that we do not include active management in the Fixed Income bucket. Most individuals should not trade individual bonds. These markets are generally opaque and the playground for professional investors. A round lot is $1 million face value and one generally does not get good execution until you trade $10 million lots.

We think your Strategic Asset Allocation should make room from both active and passive investing. We like to use Index Funds for the core of the passively managed portfolios. Then the self-directed investor should take control of the active management portion of the portfolio. This is where TheOptionsEdge.Com comes into play. We help our subscribers make decision based on current market conditions. This might involve “Tactical Asset Allocation” from time to time, but our real emphasis will be on and security selection and trade structuring. Tactical Asset Allocation makes changes to the Strategic Asset Allocation based on current market conditions. Think of it as having some lea way around the Strategic Asset Allocation. Sometimes individual securities become risk or cheap. Active management seeks to purchase undervalued assets and sell overvalued assets in order to add value and outperform the popular market averages. Subscribers to TheOptionsEdge.Com get help finding those opportunities. Once identified, we help those self-directed investors structure those investments buy simply buying the stock or ETF, or structuring a trade using options to achieve the desired risk return tradeoff.

Strategic vs. Tactical

Strategic asset allocation is different from Tactical Asset Allocation. Strategic Asset Allocation is fixed and static. Tactical Asset Allocation is dynamic. It focuses on the timing of how you move money in and out of investment categories and asset classes.

Lets say, you think the economy is going into a recession. A Tactical Asset Allocation move would call for a reduction in equities and real estate below the Strategic Allocation and an Increase in an Allocation to Bonds and Cash. It can also impact holding within an asset class. Lets say you are bullish China. In a Tactical Asset Allocation move, one might increase their allocation to China by purchasing a China specific ETF and reducing the holding in US or International equities. The equity holding remains the same, but the country allocation changes.

When one makes a Tactical move in Asset Allocation, they tend to have a time horizon of a few months to a year. This is the case as one is usually looking for a cyclical move in asset prices. Strategic Asset Allocation focuses on secular trend in markets and economies that take decades to play out.

The tactical approach takes more expertise, of course, and there are no guarantees it will deliver better results. The decision rules one uses must actually capture what is taking place in real-time.

Here at TheOptionsEdge.Com, our focus is to help our subscribers make informed decisions so they can stay in sync with what is happening in the markets on both a short-term, cyclical and secular basis. We aim to keep you on the right side of the trends. As such, we will provide information subscribers should find valuable in the formulation their own customized Tactical Asset Allocation.

This service is a “sweetener” to our real objective, which is to help you with the active management segment of your portfolio. Get this right and you can see your portfolio grow handsomely.