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 ultimate strategy of tactical asset allocation 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, in that it focuses primarily on asset allocation and secondarily on investment selection. Learn more about how tactical asset allocation works and how to use it in your own investment strategy.

What Is Tactical Asset Allocation?

Where some investment strategies might focus on specific asset choices, a TAA strategy focuses on keeping the ideal mix of asset types to fit the investor's desired risk level. It requires actively watching how different asset classes are performing and adjusting your allocation accordingly.

Instead of simply deciding on an asset mix and sticking to it, a tactical investor would choose that initial mix and then 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.

  • Acronym: TAA

How Tactical Asset Allocation Works

The investor employing tactical asset allocation may arrive at a prudent mix of assets suitable for their risk tolerance and investment objectives. If this investor chooses 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 the investor's objectives, the allocation to a particular asset (or more than one asset) can be either neutral-weighted, over-weighted, or under-weighted.

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

For example, consider the 65/30/5 allocation given above. This is the investor's target allocation; all of the assets are "neutral-weighted." Now assume that market and economic conditions have changed and valuations for stocks become relatively high and a bull market appears to be in the maturity stages. The investor now thinks stocks are overpriced and a negative environment is near. The investor 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, the investor has 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. The investor may attempt to be almost completely in bonds and cash by the time bear market conditions are evident. At this time, the tactical asset allocator will consider slowly adding to their stock positions in preparation for the next bull market.

It is important to note that tactical asset allocation differs from absolute market timing because the method is slow, deliberate, and methodical, whereas timing often involves more frequent and speculative trading. Tactical asset allocation is an active investing style that incorporates some passive investing and buy-and-hold qualities because the investor is not necessarily abandoning asset types or investments but rather changing the weights or percentages.

Tactical asset allocation 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, and those that choose to actively manage their investments can use the tactics described here.

Tactical Asset Allocation for Long-Term Growth

Investors and financial advisors who choose to invest using tactical asset allocation are looking at the big picture. They likely subscribe to the modern portfolio theory, which essentially states that asset allocation has a greater impact on portfolio returns and market risk than individual investment selection.

You don't need to be a statistician to understand the basic premise behind tactical asset allocation. Imagine a fundamental investor who has done a good job of research and analysis. Perhaps they have a portfolio of 20 stocks that has consistently matched or out-performed S&P 500 index funds for three consecutive years. This would be good, right?

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

The point is that asset allocation is the greatest influencing factor in total portfolio performance, especially over long periods of time.

An investor can be poor at investment selection but good at tactical asset allocation and have greater performance, compared to the technical and fundamental investors who may be good at investment selection 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 investment types for the tactical asset allocator because, once again, the focus is primarily on asset classes, not the investments themselves. For example, the mutual fund investor can simply choose stock index funds, bond index funds, and money market funds, as 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 tactical asset allocator may choose sectors they believe will perform well in the near future and intermediate term. For example, if the investor feels real estate, health, and utilities may have superior returns compared to other sectors over the coming years, they may buy ETFs within those respective sectors.

Here's 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 allocations demonstrate a sample target allocation for a moderate investor. To change weights, the tactical asset allocator can increase or decrease allocation percentages in certain areas to reflect the investor's expectations of near-term market and economic conditions. The investor may also choose to alternate other sectors, such as energy (natural resources) and precious metals.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.

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.