Fundamentals: Intro to Tactical Asset Allocation

Intro to Tactical Asset Allocation

Concept

Have a semi-active portfolio that you can invest in that outperforms the 60-40 (60% Stock, 40% bond) static portfolio over the long run with a reduced maximum loss.

Investing in an index fund (eg. the S&P 500) is the “standard” passive strategy people use, but those who have done that experienced a 50% loss of their capital in the last 20 year multiple times. Depending on when you invest, your balance could be negative for 10 years. And we’re not even talking about what happened in Japan.

The annual average returns of investing in the stock market is around 8%. But every year, you may expose yourself to losing 50% of your investment. Over a short period, you’re risking 50% to gain 8%. This is not a risk I’m personally willing to take.

With “Tactical Asset Allocation”, your main goal is to protect your capital from the almost catastrophic loss a recession would mean if you were invested only in the stock market.

These strategies are built to prevent that, they have simple mechanisms to avoid losses similar to what happened in 2008 last time. As a trade-off, you may not have earned as much in certain situations. If you only look at the period between 2015-2020, you may earn less than if you invested 100% of your money in the stock market.

Ilya Kipnis, a researcher in the field described it as such:

Sorry for being so late to the party, but as someone whose strategies are featured on allocatesmartly and who has been blogging about this for years to the point of being viewed as one of the most helpful resources on the quant blogosphere, the answer is really, really simple.

Because if you buy and hold, I hope you like losing half of everything, or more–twice over, in a span of 20 years.

Take a look at the S&P 500’s equity curve. It makes around what…8% a year or so annualized, with a drawdown of more than 50%? If we’re being generous, you’re risking $50 to make $10. That’s just plain stupid.

If there’s anything TAA is particularly good at, it’s avoiding being stupid and losing a large chunk of money. Sure, you might get occasionally whipsawed, but you’re not suddenly going to shit the bed and drop half of everything in the span of six months because you stick your head in the sand and pray to the long term investing gods.

Or another way you can look at things is like this: rather than viewing buy and hope (or buy and HODL) as the default, look at TAA as the default. Instead of massive left tail risk like in 2008 or the 2000-2003 bear market, you have the occasional whipsaw risk like in 2015-2016.

Which risk would you rather bear? Getting blown up, or taking a smaller series of losses on the occasion?

Because one is a really stupid risk to take. The other at least keeps you going.

Two more things important things to add: By reducing the drawdowns compared to the classic 60-40 portfolio, you’re opening up the possiblity of higher compounded returns (which large drawdowns are the the arch enemies of) and the option to add leverage to your portfolio, therefore potentially realise higher overall returns than market.

What this will and will not do for you?

You’ll experience modest when there’s a boom.

You’ll not experience extraordinary losses when there’s a recession.

You’ll experience less volatility on your portfolio.

You’ll need to invest into opening an account with a broker, and learning how to re-balance your portfolio once a month. You’ll probably make mistakes while you do that. I did.

You’ll be free of discretionary decision making, and you won’t need to second-guess your decisions all the time. There’s no need to time the market, or worry about timing the market.

How?

Tactical Asset Allocation strategies invest in broad asset classes like stock indices (ex. SPY), bond indices (AGG), and gold (GLD). Unlike a traditional buy & hold portfolio, TAA is able to enhance returns and minimize losses by increasing allocation to assets expected to outperform, and reducing allocation to assets expected to underperform. TAA strategies tend to trade once a month or less, capturing major market trends and ignoring day-to-day noise. That makes them easier to follow for traders who refuse to be glued to a monitor all day.

To learn more about TAA, visit AllocateSmartly. Check out their blog, and their FAQ, etc! It’s really interesting and valuable.

How does it work?

You can combine multiple, uncorrelated Tactical Asset Allocation strategies.

Each of these strategies on their own have their weaknesses/strength. Blending uncorrelated weaknesses/strengths is the key (only way?) to get high risk-adjusted returns.

What’s the work involved?

You need to log in to your investment account and rebalance your portfolio each month (if required), on a specific day, after getting the “weights” of the assets from AllocateSmartly.