Oct 27, 2023 6 min read Concepts

How to Use Tactical Asset Allocation to Improve Buy & Hold

How to move beyond simple buy & hold to improve your returns and reduce your drawdowns without increasing your risk.

Strategic Asset Allocation

Everyone chooses how to “invest” their extra cash, whether putting it under their mattress, buying lottery tickets or visiting a casino, investing in whatever their advisor at the bank tells them, or buying shares of their favourite tech company. Whether simple or sophisticated, the strategy behind that selection is called strategic asset allocation (SAA). In more technical terms, SAA is choosing one or more assets, allocating a fixed percentage of your money to each with the goal of delivering decent returns with acceptable volatility.

Usually, once you’ve selected percentages for each asset, you intend to maintain those ratios over time. So, at some regular interval, you reallocate money from the winners to the losers to prevent your portfolio from becoming lopsided. This rebalancing will happen automatically if you use any sort of managed asset or portfolio.

Styles

There are an endless number of ways to allocate your portfolio. Here are a few typical examples:

Very Aggressive — 100% stocks
Aggressive/Growth — 80% stocks, 17.5% bonds, 2.5% gold
Balanced — 50% stocks, 47.5% bonds, 3.5% gold
Conservative — 35% stocks, 62.5% bonds, 2.5% gold
Ray Dalio All Weather Portfolio — 30% US stocks, 40% long-term treasury bonds, 15% intermediate-term treasury bonds, 7.5% commodities, 7.5% gold
Meb Faber Ivy Portfolio — 20% US stocks, 20% international stocks, 20% intermediate-term bonds, 20% commodities, 20% real estate
William Bernstein No Brainer Portfolio — 25% large-cap US stocks, 25% small-cap US stocks, 25% international stocks, 25% short-term bonds
David Swensen Lazy Portfolio — 30% US stocks, 15% international stocks, 5% emerging market stocks, 15% intermediate-term treasury bonds, 15% TIPS, 20% real estate

SAA is based on work published in 1952 by Harry Markowitz called Modern Portfolio Theory. The main idea is that by choosing a set of diversified (uncorrelated or negatively correlated) assets and looking at their historical volatility, you can construct a portfolio with a predictable level of volatility that maximizes your returns.

I suspect that most investors rely exclusively on SAA when investing, in that they pick a few mutual funds (or maybe ETFs) and buy & hold them for decades. The primary benefit of SAA is that it’s easy to implement and has zero maintenance—once a year, you contribute to your retirement account, buying more of your existing investments. Or maybe you have a retirement savings plan with your job that lets you contribute a small amount from each paycheque.

Drawbacks

The biggest drawback of SAA is that it’s a buy & hold strategy. In market downturns, you’re expected to ride the market rollercoaster and watch your more volatile assets ride up and down like a yo-yo. No matter how you partition your portfolio, there’s only one slider you can move—higher volatility & higher returns versus lower volatility & lower returns. Unfortunately, people believe the only option to avoid short-term discomfort is to switch to less volatile assets, which is usually a poor choice.

It is often said that you can’t outperform the “big guys”. They have their fancy supercomputers and hundreds of analysts, and you’ll never be able to out-analyze the market against them, which is true. But you have one significant advantage over them—you’re small and nimble. Why don’t mutual funds sell as markets decline into recessions? Because unloading hundreds of millions or billions of dollars of stock efficiently is impossible. Who are they going to sell to? So, what if you could leverage the advantage of being small?

Tactical Asset Allocation

If strategic asset allocation is about choosing assets and allocations once, tactical asset allocation (TAA) is about making course corrections regularly—using tactics to exploit your ability to move quickly to “finesse” the market.

A trivial example could be changing the allocation ratios of your portfolio as you approach retirement, reducing volatility to lessen the risk of a significant drawdown just as you’ll need the money.

Another example could be changing your portfolio allocation based on bull versus bear markets. For instance, you could alternate between fully invested during bull markets and partially or entirely in cash in bear markets. Despite being maligned by many, market timing is a viable strategy and one I suggest.

Rotating

A newer style of TAA strategy, referred to as a sector rotation strategy, has been gaining popularity recently. This strategy has been popularized by people like Meb Faber, Gary Antonacci, and Brian Livingston (see recommended reading). The basic idea is to have a method of ranking a basket of assets, then aim only to own the top-ranked assets, updating them regularly (e.g. monthly, quarterly).

The most used (and I’d guess most effective) ranking functions exploit momentum. The reason is that momentum is a persistent anomaly in the markets, meaning if we assume the markets are efficient (and random), then momentum should not exist. Yet, it has persisted a hundred years after being discovered and documented.

The essential feature of market momentum is that markets will trend upwards and downwards longer than expected. In mathematical terms, the statistical distribution of the returns is not normally distributed—the returns distribution bell curve has “long tails”.

Momentum is likely due to “herding”—people following the fear/greed emotional cycle in and out of assets. The Efficient Market Hypothesis presupposes market actors are rational, but that seems like an unwise assumption. So, as long as humans remain involved in the markets, momentum is likely to exist.

A simple way to demonstrate momentum is to take a basket of ETFs and look at next-month performance versus their momentum ranking (average of most recent 3, 6, and 12-month performance). Here is a summary of the performance of my global diversified portfolio, which uses 13 assets.

Next-Month Return vs. Momentum Rank

Rank	Average	Maximum	Minimum	% Positive
Top 3	1.05%	25.0%	–17.1%	59%
Top 6	0.92%	25.0%	–31.7%	61%
Bottom 6	0.46%	30.8%	–34.4%	56%
Bottom 3	0.41%	30.8%	–34.4%	54%

Notice that while the lowest-ranked assets boast the best (and worst) months, the average monthly returns and % positive months show a clear correlation between performance and rank. This relationship is not unique to this particular set of assets. It appears across many (most?) baskets of diversified assets (at least that I’ve found).

We can exploit this type of statistical edge to build an investment strategy. Our primary goal would be to choose assets that have solid returns, are diversified, and are not strongly correlated. I suggest several low-effort strategies that use different combinations of assets that will handily outperform most investors.

Drawbacks

The most significant disadvantage of TAA is that you’re selling (as opposed to just buying & holding). This means it requires more effort and monitoring and has tax consequences if you invest outside a tax-sheltered account.

However, given the ability to outperform the markets and significantly reduce drawdowns, the benefits vastly outweigh the costs.

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Check out our list of free strategies that use these concepts to deliver superior returns.

Key Points

Strategic Asset Allocation is choosing a set of complementary assets and rebalancing them regularly, aiming for decent returns while reducing volatility and risk.
SAA suffers from the same problem as all buy & hold strategies: your most volatile assets will still experience significant drawdowns, and you’re limited in how much you can reduce your drawdowns without diminishing returns.
Tactical Asset Allocation is a set of market timing tools that can enhance SAA and reduce its inherent weaknesses.
Sector rotation TAA strategies are a popular, successful, and well-studied way to reduce volatility and improve investment returns.

Points to Ponder

Do you believe it’s possible to time and outperform the market?
Would you have the time and inclination to learn about TAA if it let you handily beat the market while reducing your volatility?

Strategic Asset Allocation

Styles

Drawbacks

Tactical Asset Allocation

Rotating

Drawbacks

Key Points

Points to Ponder

Related Concepts

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