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The Real Secret of Diversification is Tactical Asset Allocation

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Tactical asset allocation sounds intimidating, but it's nothing more than the old saying "don't put all your eggs in one basket".

It's a way for you to balance the assets you plan to buy (or sell). Stocks are one type of asset and bonds are another.

As Barry Ritholtz says on his blog, The Big Picture, "Stock picking is for fun. [Tactical] asset allocation is for making money over the long haul."

If you want proof, just take a look at stock market returns in 2008 in the chart below.

Everyone that tried to find the world's best stock probably ended up losing money. You would have had better returns putting your money in a savings account! Bonds performed well...nothing too exciting.

Fast forward to 2009...cash was the lowest return (without losing money of course). Bonds performed about the same, and stocks exploded higher. You could have picked stocks by throwing darts at the business section and everyone would have complimented you on your stock picking prowess.

What is Tactical Asset Allocation?

Simply put, tactical asset allocation is putting your money into investments that don't behave the same way at the same time.

The goal is diversification; to spread your money across several different types of assets, so that no one asset class will make or break your personal finances.

This means that "diversification" is actually the result or outcome tactical asset allocation. If you want diversified investments, you need to use tactical asset allocation.

At a high level, you can group all the different types of investments into their respective asset classes to get a rough idea of how well or poorly you're diversified.

Why is Tactical Asset Allocation Important?

Prices are very dynamic. For example, what will happen to the stock price of your favorite company when the CEO retires? Or if they face a huge recall? Will it rise or fall? For how long? You just don't know.

The same principle applies to long term investing; you cannot predict the future price exactly. You might get the price right, but the timing wrong. Or you might get the timing right for an increase, but be way off in the magnitude.

So how can you plan to achieve the average 6%-8% that "common knowledge" says you will need to earn on your money until you retire?

Tactical asset allocation attempts to capture price increases during long-term trends in different asset classes.

Studies[1] have shown that the most important factor for the return of a portfolio of investments was the number and weight of specific asset classes (how many and how much of each, respectively).

Color table showing asset class returns from 2004-2013
Performance of different Asset Classes from 2004-2013
Click on the image to enlarge

[Source:Guggenheim Investments]

As you can see in the table, no one asset class is always the best. Look at "International Equities" from 2008 to 2009; down ~43%, then up ~32%. Your returns in 2008 and 2009 would depend heavily on how much you owned and when you owned it.

Benefits

Diversification

  • Asset class prices normally move in different directions
  • This means that when the stock market falls in price, other asset classes (such as gold or bonds) usually rise in price

Drawbacks

The illusion of safety

  • Asset allocation and diversification reduce the impact of one asset class on your overall investment portfolio, but no investment is risk free.
  • This is why position sizing is so important.

Requires Time and Attention

  • As prices rise and fall, asset allocation percentages within your portfolio change
  • If you don't monitor your holdings, being too successful becomes a bad thing, making your portfolio lopsided (which is called "overweight")

No Guarantees

  • Asset allocation is based on historical performance, and you've hard it before; historical performance is no guarantee of future returns

Correlation is not causation

  • Macroeconomic issues can cause all asset classes to move together (fall/rise) in price at the same time
  • This occurred in 2008 during the Great Recession

As you can see, tactical asset allocation isn't without it's drawbacks, and it's not fool proof. Investing involves some level of risk. The goal of safe investing is to reduce that risk.

How To Use Tactical Asset Allocation

Asset allocation is essentially a type of buy and hold or "passive" investing. Instead of just sitting on a bunch of stocks and bonds (e.g 60/40 split between stocks and bonds), you're spreading your money around asset classes as well; gold, silver, real estate, currencies, etc.

The "tactical" part comes from your investing process; specifically trading or "active" investing. The goal is to get the bulk of your money into something that is going up in price (or at least not going down as much!).

Ideally, the gains are higher than the losses, and the result is a slow, steady growth in your overall portfolio.

A Thought Experiment

A "bull market" in equities normally lasts 4-5 years before running into a correction (historically speaking). Looking at the asset class table above, you can see that the S&P500 fell from 2000-2002, then rose from 2003 to 2007, fell in 2008, and then started to rise again from 2009 to 2013.

You're always protecting against loss (preservation of capital), you have already selected the maximum loss that activates your sell rules. As the market rolled over during the second half of 2007 and into 2008, your sell rules would have triggered and a larger portion of your portfolio would be in cash.

You may have decided to stay in cash and waited for equities to rebound. Or, maybe you decided to shift money into bonds or a currency fund for a year or two.

You're "tactic" is evaluating the situation, and looking at asset classes that historically rise when equities fall (i.e. you're looking for assets with a beta of -1).

This way, when one asset price was tanking, you were increasing your exposure to something that wasn't.

Notice I did not mentioning selling all your stocks and dumping all your money into x,y, or z.

You won't know ahead of time how long an asset class will rise in price. And moving your money isn't free (commissions and redemption fees apply), so only move enough to protect your overall portfolio from loss and leave the rest alone.


[1]Source: Financial Analysis Journal, B.G.P. Brinson, B.D. Singer and G.L. Beebower - June 1991]