The Tactical Investor
Trying to time purchases or sales of financials like Goldman Sachs(GS) or Citigroup(C) over the last year could have resulted in devastating losses.
Likewise, emerging-market ETFs like Market Vectors Russia(RSX) and iShares FTSE/Xinhua China 25 Index(FXI) have vacillated dramatically during the economic slump and recovery.
Now, more than ever, it is increasingly important to understand the difference between tactical and market timing. While performance chasing and market timing may be tempting, the difficulty of forecasting broad short-term market movements makes that strategy unworkable: Numerous studies have shown that market-timing investors are far more likely to miss out on market gains than they are to avoid market losses.
Tactical allocation, on the other hand, involves making occasional modest tweaks to strategic allocations to adjust for realities and opportunities in the capital markets. For example, stocks historically have outperformed bonds when the economy shows signs of picking up steam, because an accelerating economy makes it easier for corporations to generate profits and cash flow.
Bonds, on the other hand, often suffer when an economy strengthens, because the expanding economy generates inflationary pressures and triggers higher interest rates. Given that backdrop, a tactical investor might want to boost her stock allocation slightly and decrease her bond holdings commensurately.
Tactical allocation assumes that market cycles present opportunities for investors who are observant and disciplined enough to capitalize upon them. The extremely divergent performance of small- and large-cap stocks led to massive valuation discrepancies at the end of the 1990s.
Investors who believed that small-value stocks eventually would come back into favor — those who had discipline to increase their small-value stakes following a half-decade of subpar performance — were amply rewarded during the subsequent six years, as stock returns reverted to their long-term averages.
Many investors in the late 1990s probably boosted their small-cap holdings long before the market turned in their favor, and they had to wait for months or years before their tactical allocation decision paid off.
That kind of patience represents another key distinction between tactical allocation and market timing: Whereas market timers attempt to buy at a market low and sell at a peak, investors using tactical allocation simply try to increase exposure to assets that they believe have a higher probability of superior performance going forward.
Such investors recognize that the market might take a long time to come around to their point of view. For that reason, investors making tactical allocation decisions typically deviate only modestly from their long-term strategic allocation targets. That allows them to maintain exposure to any growth that occurs in other parts of the market.
Indeed, tactical allocation involves acknowledging and planning for the possibility that allocation decisions could be flat-out wrong. The best investors, from Warren Buffett to Peter Lynch to Legg Mason Value’s Bill Miller, are united in their humility: They know they won’t get every investment decision right — but they also know that they don’t need to. That approach is very different from market timers’ all-or-nothing results.
Active investors may want to tweak their asset allocations based on their own takes on the market. Such investors should be cautious, however: Frequent trading can open the door to emotional investment decisions and higher trading-related costs, which typically result in lower investment returns.
. Annual rebalancing might offer an opportunity to take stock of the prospects for various asset classes and to boost exposure modestly to those that look poised for superior performance.
Remember to keep any tactical shifts small, no matter how strong your convictions are that a particular investment is ripe for a rally. Say your domestic stock portfolio currently holds 70% in large caps and 30% in small caps, and you decide to boost your exposure to blue-chips. You might want to sell at most a third of your small-cap stake and invest the proceeds in a fund that holds the market’s largest stocks, bringing your large- and small-cap allocations to 80% and 20%, respectively. Resist the urge to make more-dramatic shifts.
As the late British economist John Maynard Keynes once famously said, “The market can stay irrational longer than you can stay solvent.”
