Understanding the Basics of Strategic and Tactical Asset Allocation
InCred Wealth September 20, 2022
As an investor, you are focused on one thing – maximising your returns, adjusted for risk, over the course of the investment tenure. How do you make this objective a reality? The first thing you should remember is that, while higher risk correlates to higher potential for returns, a healthy portfolio must have an optimal combination of risk and security. If this is not the case, you might suffer unprecedented downsides on your investment, even losing substantial sum of your wealth on occasion. So how do you go about maximising returns potential and minimising the risk? This is where asset allocation comes in. When you divide your portfolio into different asset classes which have a low correlation between them, you will end up earning optimal returns from each category, while also limiting the loss you may face if one of the asset classes witnesses drawdowns.
For example, during the Global Financial Crisis (2008 – 2010), almost all asset classes, including debt and equity, saw severe drawdowns. In 2008 itself, the BSE Sensex Index fell from 19,013 points in January to a low of 8,701 in October 1 . While this plunge wiped out a tremendous amount of investor wealth, people who had invested in the haven yellow metal managed to mitigate their losses. Gold prices remained resilient.
In the current times, there are multiple investment opportunities available, apart from the traditional investment avenues such as mutual funds, direct equities and bonds. These include private equity, venture capital, structured credit, market linked debentures, offshore investments to name a few. These investments have the potential to add an element of alpha to your portfolio. However, can they become a core part of your portfolio? Probably not. Thus, while it is well-known that asset allocation is the cornerstone of a robust long-term portfolio, it is equally important to get the asset allocation right. the first step to enable this is to understand the two ways by which asset allocation can be done – strategic and tactical. Let us look at how to leverage these two techniques in the most optimal manner.
Strategic Asset Allocation:
Under this strategy, you can set target allocations for different asset classes, based on your risk profile, investment goals, time horizon and return expectations. Once this is done, based on your evolving requirements, and the changes in the market, you can periodically rebalance the portfolio to stay aligned with your underlying asset allocation strategy. This is a comparatively less active technique as you will stick to your asset allocation strategy throughout different market scenarios.
Tactical Asset Allocation
In this strategy, you will have to take an active stance on the asset allocation and adjust your exposure to various asset classes based on short-term market trend and opportunities. For instance, if you see the IT sector valuations to be attractive, you may want to go overweight on the sector, this is a relatively active strategy which requires closely tracking the markets as well as being nimble footed in taking decisions aimed at capitalizing on the available opportunities.
Now that you know the two different styles of asset allocation, how can you combine the two to optimize your portfolio returns? Start with creating an investment charter / investment policy statement that captures all the factors such as asset class mix, returns expectations, restrictions, cash flow / liquidity needs, restrictions etc. This will help arriving at your strategic asset allocation. However, while you do this, remember to keep some dry powder / liquidity in the portfolio as this will allow you to participate in emerging tactical opportunities. What is critical is to also monitor the portfolio periodically. It helps in ring fencing the gains that such tactical opportunities provide by getting out at an appropriate time and waiting for the next opportunity to redeploy your money. While doing this, one must follow the discipline of not going overboard in rejigging the portfolio too frequently as you need to be mindful of the transaction costs and taxes that are incurred. Tactical portfolio generally shouldn’t be more than 20% - 25% of the overall portfolio. Prudent investing is all about striking the right balance between staying invested for long (buy and hold) in large part of the portfolio while identifying and taking measured exposure to opportunities that markets keep throwing at you from time to time.