Lowering Risk with Tactical Asset Allocation

By Andrew Willms, Founder & CEO

In last week’s article, I mentioned that The Milwaukee Company favors a tactical asset allocation (“TAA”) approach to portfolio management. This week, I would like to elaborate a bit on what TAA is, and to consider both its strengths and weaknesses.

Generally speaking, TAA refers to rules-based investment strategies that adjust the amount invested in different asset classes and market sectors in response to changes in market and economic conditions. More specifically, quantitative TAA involves the development of algorithms that mathematically determine which securities are to be held in client accounts, the share of the account to be allocated to each of the included securities, or both.

Most TAA strategies lower exposure to riskier assets when economic and/or market data suggest trouble is lurking, and vice versa. As a result, TAA creates the potential to generate higher returns than a passively managed portfolio of the same assets with the same level of risk.

Another benefit of TAA is that because it is rules based, it limits the role emotions play when making investment decisions. This is critical because as behavioral psychologists have repeatedly demonstrated, the innate behavioral biases we all share (including overconfidence, confirmation bias, and loss aversion, to name a few) can cause even the most seasoned and intelligent investors to make regrettable decisions. (You can find a discussion of behavioral finance here).

A third advantage to TAA: because it is rules-based, strategies that utilize TAA can be thoroughly tested and studied. That’s an advantage that’s not possible with many if not most qualitative strategies, which rely on unwritten rules executed by managers. As a result, the ability to examine how a TAA strategy would have done in the past, and to use simulations to forecast how a TAA strategy can be expected to perform in the future, can provide the confidence needed to stay the course when the stock market acts up.

TAA is not perfect, however, as its struggles during the Covid-19 pandemic have demonstrated. One of its potential weaknesses is its dependency on timely market and economic data. A delay or disruption in the receipt of such data can cause TAA strategies to generate below-market returns when the stock market changes course suddenly. Sudden market reversals can cause TAA strategies to sell a security when the market is falling, only to buy it back again at a higher price after the market unexpectedly springs back.

Rather than rely on TAA entirely, The Milwaukee Company uses a multi-tiered approach to address TAA’s inherent weaknesses.

  • Strategy Diversification. Rather than relying on a single investment strategy, I recommend the use of multiple TAA strategies, each focusing on different market factors to generate positive results. The advantage of strategy diversification is that if market conditions are not conducive to one strategy, those same conditions may cause another strategy to out-perform.

  • Hedging. I also suggest TAA investors monitor forward-looking economic and market indicators in an effort to identify when the risks of a market bubble or adverse economic conditions are increasing. If those indicators suggest risk is unusually high, then option contracts can be enlisted to lower the risk.

  • Strategic Intervention. While a willingness to stay the course is an important component of TAA’s success, it’s equally important to recognize that on occasion markets can move too quickly for TAA strategies to keep up. The recent history-making stock market sell-off and its equally dramatic recovery is a great example. In those circumstances it may be necessary to deviate from portfolio changes directed by TAA strategies to limit the risk of being whipsawed.

No investment approach is perfect. However, I believe an investment approach that has TAA at its core, combined with strategy diversification, periodic hedging and occasional instances of strategic intervention is a recipe for investment success over the long-term.

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