Strategic vs. Tactical vs. Dynamic Asset Allocation

Before creating a portfolio, you need an asset allocation strategy. Specifically, you need to know whether to allocate your assets in a strategic, dynamic, or tactical method. All methods can move your portfolio toward the ultimate goal of diversification. But your financial goals, investment skill, personal risk appetite and aggressiveness in seeking rewards will inevitably push you toward one asset allocation model over the other. Once you understand the differences between the dynamic, strategic, and tactical asset allocation paradigms you can properly implement an optimal mix of assets in your portfolio.

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Summary

  • Strategic asset allocation sets static benchmarks for each asset class based on an investor’s risk profile and long-term financial goals.
  • Tactical asset allocation makes short-term adjustments to the asset mix based on the current risk/return profiles of each asset class, given the current market conditions.
  • Dynamic asset allocation yields a constantly changing asset mix based upon changing market and economic factors. 

Strategic vs. Tactical Dynamic vs. Asset Allocation – What’s the Difference?

Timing is the most salient differentiator among these allocation methodologies. That is, both investment horizon and your frequency of rebalancing will push you toward a specific strategy. We will review the general heuristics for each allocation type, but first understand the asset allocation concept and its importance.

What is Asset Allocation?

Asset allocation is a means of reducing portfolio risk and possibly increasing the expected return over time. More specifically, asset allocation is your division of capital into different asset categories – traditionally stocks, bonds, and cash. Your risk tolerance and investment time horizon come into play here, as they influence the proportion of capital you will ideally dedicate to each category.

For example, an investor with a low risk tolerance and a short investment horizon, such as a person planning to retire in the next few years, will likely put a greater amount of capital into cash and bonds so as to not expose herself to too much risk. More aggressive investors with long investment horizons will allocate more capital to stocks and stock funds. The growth potential (and risks) is higher with such assets, and – even though that growth comes at the price of increased risk – aggressive investors with long-term investment horizons can weather a short-term pullback in their portfolios. 

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Why does Asset Allocation Matter?

Why is asset allocation important?

Asset allocation doesn’t just matter – it’s one of the most important decisions an investor can make! Not only does it determine the expected growth of your portfolio, but it also determines the proportion of your capital that can disappear in an unfavorable market situation-like a stock market crash. That is, asset allocation allows you to estimate and control both your maximum loss and control your portfolio’s general growth rate, thereby letting you hit your financial goals.

Of course, all growth and loss projections are based upon historical returns, as the perfect crystal ball hasn’t been invented yet. This means there’s no perfect assurance that your projections will pan out.  

An important difference between a successful investor and an unsuccessful one is that the successful investor tends to focus on asset allocation, while unsuccessful investors tend to focus on the assets themselves. Arguably, the average investor spends way too much time comparing individual stocks or bonds and not enough time deciding exactly how much capital to invest in said stocks or bonds. An investor who deeply considered his financial goals and risk tolerance will, in the end, be better off than an investor who deeply considered the nuances between two individual publicly traded companies. 

By learning of the different types of asset allocation methods, you’ll be one step ahead of the majority of your peers. 

What is Strategic Asset Allocation?

Strategic asset allocation, in contrast with dynamic asset allocation, focuses on longer-term financial goals, and the investors risk tolerance. This is the most common type of asset allocation. For a portfolio employing this asset allocation strategy, 90% of returns come from long-term positions according to Vanguard research.  The strategic approach places a set proportion of your capital into each asset category. That proportion remains the same, as long as your financial goals and risk tolerance endure. 

With strategic asset allocation, when the desired asset class proportions deviate from the desired percentages, then the portfolio is rebalanced. 

For example, consider a 60% stock, 40% bond portfolio. If your stocks do exceptionally well, your portfolio could become a 70%/30% stock/bond split over time. Adhering to the strategic asset allocation design, you would sell down your stocks to 60%, while buying bonds with the proceeds so as to rebalance your portfolio back to a 60%/40% split.

The strategic asset allocation plan works especially well for investors who want to avoid making decisions based on emotions. It also works well for those who don’t want to continually change their portfolio based on market conditions, instead sticking with a single, easy-to-follow, long-term plan (maintaining X%, Y%, and Z% in stocks, bonds, and cash). Strategic asset allocation investors might not experience the strong returns that come with more active investing, but they also don’t see large losses or fluctuations, either.

What is Tactical Asset Allocation?

Tactical asset allocation is the next variation of Strategic Asset Allocation. A baseline asset allocation is created, much like that of the Strategic Asset Allocation. But tactical asset allocation considers short-term economic or market trends. Using this information, a temporary shift from the baseline asset allocation is adjusted. When conditions warrant, the portfolio will return to its pre-determined asset mix. 

For example, an investor with a 70% stock, 30% fixed portfolio who believes stocks are overvalued and expects a near term stock market crash might shift their asset allocation to 60% stock, 40% fixed to minimize future losses, should the stock market crash. 

Once the crash is over, the investor will return to the 70%/30% stock/fixed mix. 

Investors using this method of asset allocation are looking for temporary inefficiencies in the market, such as stocks being overbought or overpriced, and capitalizing on those ephemeral market features. This is the most risky form of asset allocation but also offers the highest potential returns.

Although, predicting market movements always includes the risk that your prediction will be early or wrong.

What is Dynamic Asset Allocation?

The dynamic asset allocation investment strategy involves frequent adjusting of asset weights , based on market conditions and investment theories. This asset allocation strategy is highly flexible but also requires the investor to have sufficient time to engage in research and act on that research. 

For example, if healthcare stocks are on a tear, the dynamic asset allocator might buy healthcare sector ETFs or individual stocks. Or, if bonds are offering low yields, the dynamic asset allocator might increase a portfolio’s stock allocation.

The most notable benefit of the dynamic approach to asset allocation is the potential for higher average returns due to the ability to reallocate capital in response to a changing market. This allows investors to reduce risk when the market is looking weak and increase returns when the market is showing upward momentum. 

A portfolio managed via dynamic asset allocation requires the manager or investor to keep an eye on the market so as to react to changing market conditions. This is the main downside of the dynamic approach. A secondary disadvantage of dynamic asset allocation lies in the frequent rebalancing itself: A dynamic portfolio will incur more transaction fees than strategic asset allocation, which we will discuss next.

The same caution that we mentioned in the tactical asset allocation, holds true with dynamic asset allocation. Too many transactions in the wrong direction can result not in out-performing markets, but in under-performing a constant strategic asset allocation.

Which Type of Asset Allocation is Best for You?

Your attitude toward risk, and your skill as an active investor will influence the best asset allocation model for you. In addition, your investing experience and research tools can play a part; successful tactical and dynamic asset allocation require more investment experience and a larger research toolbox. Other factors that are at play include your current assets as well as liabilities, financial goals, and tax situation.

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