Explained: Strategic asset allocation vs Tactical asset allocation
After the asset allocation is determined, the portfolio managers distribute the capital both strategically and tactically to invest with a focus on what is best for each client.
The financial consultants or the portfolio managers determine the overall risk tolerance and objectives to determine an appropriate asset allocation. After the allocation is determined, the portfolio managers distribute the capital both strategically and tactically to invest with a focus on what is best for each client.
So, you might be wondering, “What’s the difference?”
Strategic Asset Allocation
Strategic Asset Allocation works with an aim to construct “efficient” portfolios. Efficient portfolios are the ones that maintain an optimal mix between different asset classes namely stocks, bonds, and cash, with the focus on maximizing returns for a particular level of risk. The strategic asset allocation approach involves holding on to original allocation over long periods, generally spanning a decade or more. After establishing long-term strategic allocation targets, investors will need to periodically rebalance portfolio weightings back to those target allocations.
Let us understand the same with an example - An investor establishes a strategic asset allocation target of 60 per cent stocks and 30 per cent fixed income. After a particularly strong year for the stock market, the allocation to stocks has risen to 70 per cent and fixed income allocation lowers to 30 per cent. According to the strategic asset allocation approach, the investor would reduce their stock allocation from 70 per cent down to the strategic target of 60 per cent and utilize the sale proceeds to advance the fixed income allocation back up to 40 per cent of the portfolio.
To keep investors inclined towards the right direction for the long term, appropriate asset allocation plays an important role. Strategic asset allocation underlines a framework for an investor’s portfolio by appropriately aligning their asset mix with long-term investment goals and objectives. Strategic asset allocation can be challenging in volatile market environments as rebalancing allocations back to strategic targets may lead to buying stocks in periods of market stress and economic uncertainty.
Tactical Asset Allocation
Tactical asset allocation establishes a baseline mix of assets that are suitable for an investor’s risk tolerance and investment objectives. Instead of merely deciding on an asset mix and following the same, the portfolio weightings will be adjusted actively based on short or medium-term expectations for economic conditions, valuations, market cycles, etc. This approach holds the potential to amplify returns, lower portfolio risk, and increase diversification which counts as important benefits of the same. These tactical allocation changes or shifts are taken into account and implemented to generate superior risk-adjusted returns in comparison to the otherwise strategic asset allocation approach.
To explain the same with an example - An investor decides to reduce their allocation to domestic stocks to below normal or strategic allocation levels and increase weightage to international equities on the back of favourable short or medium-term view of international stocks. This constitutes tactical asset allocation based on future market views. The tactical asset allocation process is named as a success if the tactical investment decisions achieve the goals of generating superior risk-adjusted returns compared to a strategic asset allocation approach in reality.