What Is Tactical Asset Allocation?

Definition & Examples of TAA

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Tactical asset allocation (TAA) is an investment style in which the three primary asset classes (stocks, bonds, and cash) are actively balanced and adjusted. The main goal of TAA is to maximize portfolio returns while keeping market risk to a minimum.

The TAA investing style differs from other investment strategies, such as technical analysis and fundamental analysis. That's because it focuses primarily on asset allocation and secondarily on investment selection. Learn more about how TAA works and how to use it in your own investment strategy.

Key Takeaways

  • In tactical asset allocation, an investor actively adjusts and balances stocks, bonds, and cash based on market performance to fit their desired investment goals.
  • This strategy is more focused on asset classes than the specific assets themselves.
  • It blends some passive buy-and-hold methods with active attempts to time the market.

What Is Tactical Asset Allocation?

Some investment strategies might focus on specific asset choices. But a TAA strategy focuses on keeping the ideal mix of asset types to fit the desired risk level. It requires actively watching how different asset classes are performing; then, adjust the allocation accordingly.

Instead of simply deciding on an asset mix and sticking to it, a tactical investor would choose that initial mix. Then, they would wait to see if it performs as expected. If it doesn't, they would shift the proportion of stocks, bonds, and cash to better fit their desired returns.

How Does TAA Work?

Using TAA, you may arrive at a prudent mix of assets suitable for your risk tolerance and objectives. If you choose a moderate portfolio allocation, it may be targeted at 65% stocks, 30% bonds, and 5% cash.

The part of this investing style that makes it tactical is that the allocation will change depending upon the prevailing (or expected) market and economic conditions. Depending upon these conditions and your objectives, the allocation to a particular asset (or more than one asset) can be either neutral-weighted, over-weighted, or under-weighted.

Note

Assets are said to be neutral-weighted when they perform on par with the market. Overweight assets outperform the market; underweight assets underperform.

For instance, let's look at the 65/30/5 allocation given above. This is a target; all of the assets are "neutral-weighted." Now, assume that market and economic conditions have changed; valuations for stocks become relatively high and a bull market appears to be in the maturity stages. Now, you may think stocks are overpriced and a negative environment is near.

You may then decide to begin taking steps away from market risk and toward a more conservative asset mix, such as 50% stocks, 40% bonds, and 10% cash.

In this scenario, you have under-weighted stocks and over-weighted bonds and cash. This reduction in risk may continue in steps as it appears a new bear market and recession are drawing closer. You may attempt to be almost completely in bonds and cash by the time bear market conditions are evident. At this time, the TAA user will consider slowly adding to their stock positions in preparation for the next bull market.

It is important to note that TAA differs from absolute market timing; that's because the method is slow, deliberate, and methodical. On the other hand, timing often involves more frequent and speculative trading.

TAA is an active investing style that incorporates some passive investing and buy-and-hold qualities. The investor is not necessarily abandoning asset types or investments; rather, they are changing the weights or percentages.

Note

TAA can be utilized with mutual funds in retirement accounts like 401(k) and 403(b) plans. Employees may have the option to rebalance their portfolios. Those that choose to actively manage their investments can use the tactics described here.

How Can You Use TAA for Long-Term Growth?

Those who choose to invest using TAA are looking at the big picture. They likely agree with the modern portfolio theory; this essentially states that asset allocation has a greater impact on portfolio returns and market risk than investment selection.

You don't need to be a statistician to learn how TAA works. Let's say you're a fundamental investor. You've done a good job of research and analysis. Perhaps you have a portfolio of 20 stocks that have consistently matched or outperformed S&P 500 index funds three years in a row. This would be good, right?

To answer the question, think about this scenario: During the three-year period from the beginning of 1997 through the end of 1999, many people found it easy to outperform the S&P 500. But during the 10-year period from January 2000 through December 2009, even a solid portfolio of stocks would have had roughly a 0% return. It would have been outperformed by even the most conservative mix of stocks, bonds, and cash.

The point is that asset allocation is the greatest factor in total portfolio performance. This is even more true over long periods of time.

Important

What if you are poor at investment selection but good at TAA? You may have greater performance compared to those who are good at choosing investments but have poor timing with asset allocation.

Using Index Funds, Sector Funds, and ETFs for TAA

Index funds and exchange traded funds (ETFs) are good for TAA. That's because, once again, the focus is mostly on asset classes. For instance, the mutual fund investor can simply choose stock index funds, bond index funds, and money market funds; this is opposed to building a portfolio of individual securities. The specific fund types and categories for stocks can also be simple with categories, such as large-cap stock, foreign stock, small-cap stock, or sector funds and ETFs.

When sectors are selected, the TAA investor may choose sectors they believe will perform well in the near and intermediate term. For instance, you may feel that real estate, health, and utilities may have the best returns compared to other sectors over the coming years, That means you may buy ETFs within those sectors.

Below is an example portfolio using index funds and ETFs.

65% Stocks

  • 25%: S&P 500 index
  • 15%: Foreign stock (MSCI) index
  • 10%: Russell 2000 index
  • 5%: Technology sector ETF
  • 5%: Health sector ETF
  • 5%: Utilities sector ETF

30% Bonds

  • 10%: Short-term bond index
  • 10%: Treasury inflation-protected (TIPS) bond index
  • 10%: Intermediate-term bond Index

5% Cash

  • 5%: Money market fund

The above shows a sample target allocation. To change weights, using TAA, you can increase or decrease percentages in certain areas to reflect your expectations of the near-term conditions. You may also choose to change other sectors, such as energy (natural resources) and precious metals.