Here are 19 core ideas that guide our approach to Tactical Asset Allocation (TAA) and investing:
1. Tactical Asset Allocation (TAA) strategies dynamically adjust the portfolio’s asset allocation, usually based on trend-following and momentum. These are not fleeting anomalies that are here today and gone tomorrow. They are fundamental market forces that have worked for as long as financial markets have existed. Learn more, more and more.
2. TAA isn’t just about generating return; it’s also about reducing losses and managing risk. That’s important. Losses cause investors to abandon their trading plan, usually at the worst possible moment. By providing a smoother ride, investors are more likely to stay the course (and sleep better and night).
The mechanics of TAA:
3. TAA strategies trade infrequently – usually once per month, or less. That’s by design. Most shorter-term market movement is just “noise”, and trying to perfectly time every zig and zag in the market is a fool’s errand.
4. TAA focuses on asset class indexes like the S&P 500 (SPY), not specific stocks, bonds, etc. Most of a stock’s performance can be explained by its broader asset class. Wall Street is paid billions to predict which stocks will outperform its asset class and it fails. You can’t win that game. TAA focuses on asset class indexes because they are more predictable.
5. For most investors, ETFs are the easiest way to manage a tactical portfolio. We represent each asset class with the largest, most liquid ETF available, but other ETFs and even mutual funds and futures can often achieve similar results. See our list of ETFs. European investors, we provide a list of UCITS funds as well.
Combining strategies into a Model Portfolio:
6. Investors shouldn’t trade just a single TAA strategy. That introduces “specification risk”, or the risk that we’ve bet everything on an underperforming horse. Instead, we should diversify by combining multiple strategies together into what we call a Model Portfolio.
7. Obviously, we should aim to select good strategies for our Model Portfolio, but we should also consider how the strategies perform together as a unit. That means selecting strategies with diverse approaches to trading and low correlation to each other. Here are some good places to start:
- The Portfolio Optimizer provides strategy combinations that would have maximized return and minimized risk.
- The Correlation Matrix shows historical correlation between strategies (read: what is correlation?).
- The Cluster Analysis depicts the relationship between strategies visually.
8. Most TAA strategies trade monthly, and developers usually assume trades are executed on the last trading day of the month. But when adding a strategy to your Model Portfolio, you can instead follow the strategy on any other day, or even spread changes across the month (aka “tranching”). This is an additional level of diversification. Learn more.
9. We are pro tactical asset allocation, but we are not anti buy & hold. Buy & hold will at times outperform, especially when the market is very bullish. Combining TAA and B&H can be psychologically easier to trade. You can add B&H strategies and assets directly to your Model Portfolio.
Backtests:
10. One of the best tools for understanding the effectiveness of a strategy is a “backtest”, or an estimate of how the strategy would have performed historically. But be wary of bad backtests:
- Backtest should include realistic trading assumptions about transaction costs, etc.
- Backtest should be based on high quality historical data. Backtests based on unrealistic free data sources are the norm, but they have no bearing on assets that can actually be traded. We’ve invested heavily into procuring the highest quality historical asset class data. Learn more about data quality.
- Backtests of asset allocation strategies should span multiple decades at the bare minimum. Long backtests are not necessarily good, but short backtests are always bad. These are not fleeting anomalies being traded; they are fundamental long-term market forces. Most of our backtests extend at least back to the 1970’s.
Backtests based on realistic assumptions and high-quality data of sufficient length should be a starting point. The real challenge should be looking under the surface and trying to predict future performance.
11. Be cautious of “motivation”. We are motivated to see investors succeed with TAA as a whole, but we are not beholden to any particular strategy. Be skeptical of backtests or proprietary strategies that haven’t been replicated by an independent third party (hint: we are that independent third party). Read more.
Make things easier on yourself:
TAA inherently requires more work than buy & hold because the portfolio will periodically change depending on market conditions, but we shouldn’t make things unnecessarily difficult, especially if the investor’s time is limited.
12. There’s no reason to be glued to a monitor all day. When trading a Model Portfolio, you can delay execution by a full day (i.e. trade today’s signal tomorrow) with little impact on long-term performance. Read more.
13. There’s no reason to manage a lot of small positions. You can “roll up” small positions and combine them into more generic assets with little impact on long-term performance. Read more.
Other important ideas:
14. TAA as a whole has been tax efficient, but individual strategies vary widely. We model each strategy’s historical tax efficiency – see the report. Generally speaking, selling shares LIFO has been more tax efficient than FIFO, but a mixed approach has been the best of both worlds. Of course, none of this is relevant if trading in a tax-deferred/tax-free account.
15. Interest rates are on the rise. Rate sensitive assets like government bonds are unlikely to perform as well as they have over the last 40+ years (learn more), and strategies that don’t manage exposure to those assets are likely to struggle. We estimate each strategy’s exposure to rising interest rates – see the report.
16. A major advantage of TAA strategies has been an increase in “Safe Withdrawal Rates”, i.e. the amount that could have been withdrawn regularly in retirement. That’s because TAA has done a better job than buy & hold at managing losses. We model each strategy’s historical withdrawal rate – see the report.
17. European investors who are limited to UCITS funds have multiple effective options for applying our results to UCITS funds denominated in EUR or other currencies. Read our deep dive and see our list of UCITS funds.
18. Stock market “valuation” models like the CAPE Ratio or the Buffet Indicator have some value for predicting very long-term returns, but are far too imprecise to completely rely on for investment decisions. We analyze multiple valuation models and then combine them to create a 10-year stock market return forecast.
19. And lastly, a philosophical point but one that is no less important. When it comes to investing, no one knows anything about the future with certainty. Ignore anyone who claims otherwise. Our approach to asset allocation is rooted in what has worked for decades and even centuries. But we diversify our bets, because no one – not us, nor anyone else – knows with absolute confidence what will outperform in the future.