Tip of the Month: The Difference Between Strategic And Tactical Asset Allocation

Dan Eye in Wealth Management 25 March, 2021

At Fort Pitt, our financial consultants discuss the overall risk tolerance and objectives with each client to determine an appropriate asset allocation. Once that allocation is determined, our portfolio managers will distribute the capital both strategically and tactically to invest with a focus on what is best for each individual client. So, you may be asking yourself, “What’s the difference?” For the Tip of the Month, we’d like to break it down for you.

What Is Strategic Asset Allocation?

The primary focus of strategic asset allocation is constructing “efficient” portfolios. Efficient portfolios maintain the optimal mix between different asset classes such as stocks, bonds, and cash with the goal of maximizing returns for a given level of risk. The goal of efficient portfolios could also be described as achieving the lowest level of risk or volatility for a given level of expected return. While each investor’s specific risk tolerance, time horizon, and investment objectives may result in a different strategic mix of assets, the goal is always the efficient allocation of portfolio investments.

The strategic asset allocation approach involves sticking with your original allocation over long periods of time, typically spanning a decade or more. Advocates of this approach would argue that the long-term strategic focus helps investors avoid making short-term, emotional decisions based on current market events.

After establishing long-term strategic allocation targets, investors will need to periodically rebalance portfolio weightings back to those target allocations. This rebalancing process requires systematically reducing exposure to the asset classes that have done well while adding the proceeds to the portions of the portfolio that have underperformed. Methodically paring back winners to add to the laggards facilitates alignment with strategic allocation targets and instills a formulaic process for “buying low and selling high.”

Why Is Strategic Asset Allocation Important?

Strategic asset allocation establishes a framework for an investor’s portfolio by properly aligning their asset mix with their long-term investment goals and objectives. Countless studies have shown that investors’ asset allocation is the primary driver of portfolio returns. Maintaining an appropriate strategic asset allocation is what keeps investors pointed in the right direction for the long-term.

How Strategic Asset Allocation Works

Strategic asset allocation requires establishing allocation targets for each portfolio component (stocks, bonds, and other asset classes). Key investor-specific inputs include risk tolerance, investment goals, and time horizon for investing. The process also requires an understanding of expected returns, volatility, and correlations of each asset class or portfolio component.

Once strategic allocation targets are established, rebalancing portfolio investments with those target levels is an integral part of the process. This rebalancing process can be implemented periodically, such as quarterly, every six months, or annually. Another method is to rebalance portfolio assets once a certain threshold or tolerance level has been exceeded.

Strategic Asset Allocation Example

An investor establishes a strategic asset allocation target of 70% stocks and 30% fixed income. After a particularly strong year for the stock market, the allocation to stocks has drifted up to 80%. Utilizing the strategic asset allocation approach, the investor would reduce their stock allocation from 80% down to the strategic target of 70% and use the sale proceeds to increase their fixed income allocation back up to 30% of the portfolio.

When Strategic Asset Allocation Works

Strategic asset allocation has proven to be an effective approach. However, it does require that investors maintain the discipline to follow the process. This can be challenging in volatile market environments. Rebalancing allocations back to strategic targets often means buying stocks in periods of market stress and economic uncertainty. It also translates into reducing stock exposure during periods of strong market returns when investor sentiment is usually very bullish about the future prospects for the economy and financial markets. Short-term thinking and emotions can derail the strategic asset allocation process.

What Is Tactical Asset Allocation?

Tactical asset allocation involves establishing a baseline mix of assets that are suitable for an investor’s risk tolerance and investment objectives. However, instead of simply deciding on an asset mix and sticking to it, a tactical investor will actively adjust portfolio weightings based on short or medium-term expectations for economic conditions, valuations, market cycles, etc. These tactical allocation changes or shifts are implemented with the goal of generating superior risk-adjusted returns compared to a strategic asset allocation approach.

Why Tactical Asset Allocation is Important

Proponents of tactical allocation would highlight the potential to amplify returns, lower portfolio risk, and increase diversification as important benefits of the approach.

How Tactical Asset Allocation Works

Tactical asset allocation works by actively shifting portfolio allocations in order to take advantage of market trends, economic conditions or perceived mispricing opportunities in asset classes or investments.

Tactical Asset Allocation Example

An investor decides to reduce their U.S. stocks allocation to below normal or strategic allocation levels to increase their weighting to international equities due to a favorable short or medium-term view on foreign stocks. This favorable view could be based on expectations for higher growth rates outside the U.S., cheaper valuations available in foreign markets, or some other factor that the investor expects to result in superior returns.

When a Tactical Asset Allocation Works

The tactical asset allocation process would be deemed successful if the investors’ tactical investment decisions actually achieve the goals of generating superior risk-adjusted returns compared to a strategic asset allocation approach.

Talk With an Advisor

Written by:

Daniel Eye, CFA®
Head of Asset Allocation and Equity Research
Fort Pitt Capital Group, LLC
507 N. Front Street, Harrisburg, PA 17101
(717) 260-9281 | deye@fortpittcapital.com

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