The two major approaches when it comes to building a portfolio are strategic asset allocation and tactical asset allocation. Since each style has its own strengths and weaknesses, it is important to familiarize yourself with both of them. During periods of high volatility or when you see a divergence from historical trends, tactical asset allocation can be a powerful investment tool.
The term asset allocation refers to the selection of asset classes, as well as specific assets within those asset classes, to build an investment portfolio. In most cases, investment professionals use a "top down" approach, which means they first decide which broad asset categories they should invest in and what percentage of the available cash should be invested in each broad category. Then they select individual securities. A portfolio's allocation based on a tactical strategy might be 40 percent stocks, 40 percent bonds and 20 percent currency. With this breakdown in place, your adviser would then select the specific stocks, bonds and currencies.
Tactical Asset Allocation
When relying on tactical asset allocation, an analyst will distribute funds among investment alternatives based on short-term and long-term price trends, broad economic indicators and -- most importantly -- expectations of future price swings. Tactical asset allocators believe that they can predict future price movements, at least to some extent. When using a tactical approach, an analyst may shift some money from stocks to bonds, for example, if stocks have appreciated significantly over the last three months making some "profit taking" prudent. Tactical asset allocation is an active investment strategy that involves a great deal of analysis and effort.
Strategic Asset Allocation
Strategic asset allocation is a more passive approach. Investors relying on this method either believe that they cannot outsmart the market or that it is not worth the time and effort to try to do so. Therefore, they distribute funds among investment classes based on historic risk and returns. If, for example, an investor can tolerate a swing of no more than 10 percent in the worth of her portfolio, she may limit risky assets such as stocks and construct a portfolio likely to move up or down less than 10 percent. The portfolio is then left untouched until either her risk tolerance or investment goals change.
While a tactical approach will not always work, it may allow investors who can dedicate the time and resources for deep analysis to take advantage of market swings. Especially when the prices of certain assets drop sharply and experts generally expect a recovery, a tactical approach can enhance portfolio returns. Keep in mind that you do not have to subscribe exclusively to either the tactical style or the strategic style of investing. You can switch to a tactical approach when you strongly believe that a particular asset type is undervalued, and go back to an easier-to-implement strategic approach during more normal times.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.