What Is Tactical Asset Allocation (TAA)?
Tactical Asset Allocation is an asset allocation technique that uses a target risk level to determine your portfolio’s stock/bond/cash mix. The rationale for this technique is that investors often hold too much in stocks. Tactical Asset Allocation is designed to help you better manage portfolio risks and take advantage of short term opportunities within your range of acceptable investments.
By using this technique, you can diversify your portfolio to reduce the risk of severe losses while preserving the potential for strong returns. A side benefit is that with TAA, your stock holdings are adjusted automatically to keep your risk level constant over time, which you cannot do with a buy-and-hold strategy. TAA also lets you adjust your portfolio in response to changing economic conditions.
How Tactical Asset Allocation Works
Tactical Asset Allocation works by keeping your portfolio’s expected risk level constant. The most common expected risk level is a 70% likelihood of not falling more than 10% in a year. For example, if you select a 10% Tactical Asset Allocation for your portfolio, it means that at most, your portfolio should lose no more than 10% in any given year. The illustration below shows how a fund manager may be able to maintain a constant level of risk with TAA. Keep in mind that this example is only for illustrative purposes and does not reflect the actual performance of any Vanguard® mutual fund or ETF.
In our example, a fund manager begins with a stock allocation of 100% and, as the market declines from A to B, he shifts more of his portfolio from stocks to bonds. At C, the market has declined by 10% and the investor’s TAA is satisfied. In this hypothetical example, if the investor had been using a 70% TAA instead of a 10% TAA, he would have had more money in stocks at A and less money in stocks at C. Still, his risk never exceeded 70%, which is the investor’s TAA target for this example.
There are three other common targets for portfolio expected risk: 70% at C, 60% at D, and 50% at E. If your portfolio has a target risk level of 70%, 60%, or 50%, TAA will shift the stock holdings from their current allocation to the same allocation as the bonds or cash equivalent. The illustration below shows how this would work for each of these scenarios. In this example, if the investor wishes to maintain a constant level of risk, he can keep his funds allocated as they are at A to B and D to E.
Tips for Implementing Tactical Asset Allocation
TAA can help you overcome the common human (or psychological) tendency to chase after the potential for outsized returns. By using TAA, your stock holdings are automatically adjusted to maintain your target risk level. This is especially important after a significant decline in the market, when investors too often jump back into stocks with abandon. By using this approach, you will be more likely to avoid chasing returns after significant market declines and will instead let gains occur more slowly but consistently over time.
Also, don’t make the mistake of trying to time when you should begin using Tactical Asset Allocation. You don’t have to start with TAA right when you invest in your portfolio, and it is generally better not to. Start using Tactical Asset Allocation after you have stabilized in your asset allocation plan, and then monitor the success of the strategy over time. Tactical Asset Allocation may help you develop a more balanced portfolio that includes different asset classes and market investments. You will have less risk without sacrificing potential returns.
The Bottom Line on Tactical Asset Allocation
TAA is an effective tool to help you invest your portfolio with optimal diversification and risk tolerance. As the example above illustrates, the key principle behind TAA is to use target risk levels to determine how much of each investment category (stocks, bonds and cash equivalents) should be included in your portfolio. Keep in mind that TAA does not guarantee a profit or protect against loss in declining markets. Nor is it guaranteed that you will reach your target return level or that market fluctuations will always provide opportunities for rebalancing. Use this approach with the understanding of the risks involved and with careful consideration of your investment goals and time horizon. TAA is doubtlessly a technical tool that requires a very high level of expertise and is usually adopted with complementing analysis. Fintalent’s freelance consultants including its Best – in – Class Financial Analysts can carry out appropriate Risk and Compliance analysis that would help ensure TAA’s offer the desired results.