TACTICAL ASSET ALLOCATION

Tactical asset allocation is an investment strategy that centers on altering investment proportions to take advantage of differences in expected performance of various asset classes. As an asset allocation strategy, the technique attempts to evaluate the expected performance of broad asset classes (such as stocks, bonds, and cash), rather than predicting which individual securities are likely to outperform in the upcoming period. Money managers evaluate the relative performance of each asset class, then adjust the exposure of their investment portfolios to each of the classes. In making investment decisions, proponents of tactical asset allocation often buy securities in out-of-favor asset classes.

INVESTMENT STRATEGIES

Most investment strategies divide decisions into two categories: asset allocation and security selection.

Numerous studies have shown that the vast majority of a portfolio's performance is explained by the asset allocation decision. Thus, most individuals and institutions making investment decisions begin by setting a policy asset allocation that determines the long-term proportions to be invested in each class. This policy asset allocation must be suitable for the investor in terms of risk exposure and expected return. Asset classes can be defined simply (stocks, bonds, and cash) or more precisely by subdividing stocks, for example, into categories for large and small, growth and value, foreign and domestic companies. Additional asset classes such as real estate, commodities, and derivatives can be included as well.

In deciding the specific policy asset allocation, investors must assess their own aversion to risk and their required rate of return. Risk is the possibility of an investment losing or not gaining value. Expected return is the percentage gain that an investment must produce for an investment to be made. Normally, an investment with low risk is an investment with a low return. People who are risk averse require higher expected returns from securities that have higher risk. Additionally, most investors have an overall tolerance for risk that they prefer not to exceed. The proportion of the portfolio in each asset class should reflect these risk and return issues.

Once a portfolio with the proper asset allocation has been established, the investor must still monitor its overall risk. Even a passive buy and-hold strategy will eventually deviate from the desired policy asset allocation. Asset classes that perform well during a particular period will increase their proportion in the portfolio at the expense of other asset classes. This may result in a change in risk exposure that differs markedly from that desired. Also, changes in investor age, wealth, income, or lifestyle may require reevaluation of the policy asset allocation.

TACTICAL ASSET ALLOCATION
TECHNIQUES

Like other asset allocation strategies, tactical asset allocation seeks to determine the best asset allocation using the standard approach of getting the best rate of return given an investor's risk tolerance. Adherents of tactical asset allocation forecast behavior of broad asset classes and alter these allocations based upon their expectations for performance. Since it is tactical in nature, it requires short-term deviations from the policy asset allocation and focuses on improving return at some expense to risk management. It assumes that an investor's risk tolerance is relatively stable over the long run and is flexible in the short run. A typical tactical asset allocation strategy will carefully delineate the extent to which asset class proportions may differ from the long-term policy asset allocation.

As a short-term investment strategy, tactical asset allocation is often considered a market timing strategy. This implicitly assumes that markets are inefficient (at least in the short term) and that over- and undervalued asset classes can be identified and exploited. Decisions made under this strategy are therefore driven by changes in predictions for the returns of the various asset classes.

Tactical asset allocation can also be described as a contrarian strategy. This approach assumes that outof-favor asset classes, such as those that have performed poorly in a recent period, are likely to revert to their long-term average performance. Obviously, this strategy can make some investors very uncomfortable. While most investors tend to move away from out-of-favor asset classes, investors using tactical asset allocation tend to favor the unpopular markets. If the contrarian logic is correct, such a strategy should provide superior performance relative to a more passive investment approach.

While there are many adherents to tactical asset allocation, there is no strong consensus concerning its effectiveness to improve portfolio performance. Empirical studies suggest that it is possible to forecast asset class returns over long time periods, but that it becomes more difficult as the time period shortens. Tactical asset allocation can add value only if it is driven by effective forecasting of the relative performance of asset classes over a fairly short time horizon.