Strategic vs. Tactical Asset Allocation: Achieving Goals With a Well-Planned Strategy

The choice between strategic and tactical asset allocation is an important decision each investor has to make.

As an OCIO firm serving planning-focused advisors, we have a strong preference for a strategic asset allocation approach.

However, we understand that financial planning clients often think of investing in tactical terms. Some fear recessions and want to try to time the market before a crash. Others are passionate about fundamental or technical analysis and believe their efforts will allow them to outsmart the market.

In this guide, we’ll delve into the pros and cons of tactical vs strategic asset allocation approaches. With this information, you’ll be better prepared to anticipate client mindsets and educate them about differences between each approach.

Table of contents:

1. What’s the difference between strategic and tactical asset allocations?
2. Tactical asset allocation: pros and cons
3. Strategic asset allocation: pros and cons
4. Why do some investors favor tactical approaches?
5. Educating clients on the benefits of strategic asset allocation
6. Conclusion

What’s the Difference Between a Strategic and Tactical Asset Allocation?

Strategic and tactical asset allocation strategies differ in their approach to investing. The strategic approach emphasizes setting a target allocation across various asset classes and rebalancing as needed to remain close to that target allocation.  In contrast, the tactical approach is one that attempts to take advantage of short term forecasts or perceived market inefficiencies.

Pros of a Tactical Approach

There are several features of tactical asset allocations that may be attractive to certain investors.

Potential for Higher Returns: As tactical investing attempts to take advantage of short term forecasts or perceived market inefficiencies, investors have the expectation that this strategy will outperform a strategic allocation.  The expectation for higher returns is the main reason why investors may be interested in a tactical approach.

Being Hands on Is Fun: When you have skin in the game, doing research and following the news takes on a whole new feeling. Being an engaged investor exercises the same muscles that makes games enjoyable with the added bonus of it being a hobby that earns rather than costs money.

Cons of a Tactical Approach

Despite the potential benefits of tactical asset allocation, the downsides are apparent to the well-informed investor.

Tactical Trading Hurts Returns: A study out of the University of California, which analyzed 66,000 investors, found that the most active traders underperformed the market by 6.5%.

Additionally, Fidelity famously performed a review of client portfolios to determine the characteristics of top performers. The result? Individuals who had forgotten they had accounts, or were deceased, performed the best.

Time Invested: Tactical investors who perform due diligence on individual positions and market fluctuations must invest considerably more time than passive investors.

Emotional Decision Making: Try as we may, decisions made on a tactical basis can be influenced by emotions. What sounded good in the moment may turn out to be incorrect or misguided.

Strategic Asset Allocation

Strategic asset allocation is a long-term investment strategy based on setting a predetermined asset allocation mix. It aims to generate a well-diversified portfolio that aligns with individual risk tolerances, financial goals, and time horizons.

The primary focus is maintaining a consistent asset allocation with regular portfolio rebalancing rather than adjusting to market conditions.

Pros of a Strategic Approach

There are many good reasons financial planners favor strategic asset allocation approaches for their clients.

Diversification: Strategic allocation across a broad distribution of asset classes and sectors reduces the impact of market volatility. Short-term projections can fluctuate greatly, but over the long term, an investor using this approach can predict the growth of their portfolio with more accuracy.

Discipline: Rather than pursuing maximal returns, strategic investors set life goals their portfolio will enable them to achieve. The long-term nature of this approach promotes discipline and discourages impulsive investment decisions.

Cost-effective: This approach involves considerably less trading and rebalancing than tactical approaches. This improves returns through fewer transaction costs and taxable events.

Simplified Decision-Making: Strategic allocation provides a clear framework. With predetermined target allocations, investors can make informed choices about their investments regardless of market conditions.

Cons of a Strategic Approach

The strategic approach also has important downsides to discuss with potential clients.

Limited Risk Management During Extreme Events: Predetermined allocations may not effectively adapt to rapidly changing market dynamics, leading to significant short-term portfolio losses. Over the long term, this is recoverable. But, due to the sting of loss aversion, investors may be tempted to make suboptimal decisions in response to portfolio losses.

Why do Some Investors Favor Tactical Asset Allocations?

When persuading a potential client of the value of strategic asset allocation strategies, it’s valuable to remember why some potential clients are drawn to tactical investment strategies.

Cognitive Bias: Investors can feel overconfident in their ability to outperform the market, especially if they’ve experienced a big win from a previous tactical decision.

Desire for Control: Tactical approaches can give investors a sense of control. Active involvement with their investing decisions can make them feel more empowered than if they were patiently weathering market conditions.

Media and Market Noise: Financial news outlets often highlight short-term market movements. Investors want to participate in the next big thing and avoid the fear of missing out (FOMO). Constant exposure to market noise can reinforce the idea that tactical approaches yield higher returns, despite evidence to the contrary.

Lack of Awareness: Some potential clients may simply not know the benefits of strategic investment strategies. With limited exposure to research highlighting the benefits, they may default to the more commonly discussed tactical investing methods.

How to Educate Clients About the Benefits of Strategic Asset Allocations

Wherever your clients may be in their investment journeys, the role of a financial planner is to educate clients to make the most informed decisions possible. Here are some ways you might discuss the benefits of passive investing.

Highlight Historical Performance: Providing historical studies demonstrating how consistent, disciplined investing in diversified portfolios have performed.

Discuss the Impact of Costs and Fees: If just 1% of a client’s portfolio is lost to fees per year, this can have remarkable consequences for losses in compound interest. Frequent trading and rebalancing can lead to higher transaction costs, and taxes which erode overall returns.

Provide Real-life Examples: Sharing case studies or success stories of clients who have achieved their financial goals and weathered recent market downturns through long-term planning can demonstrate the power this approach has for achieving long-term objectives.

Illustrate the Power of Compounding: Long-term compounding is part and parcel to the success of strategic asset allocations. Showing clients how sticking to a strategy over the long term leads to significant wealth accumulation compared to the potential pitfalls and uncertainties of tactical approaches.

Conclusion

The choice between strategic and tactical asset allocation approaches holds significant weight for investors. However, a challenge advisors face is that many of their potential clients may be naturally inclined toward tactical thinking.

By understanding the pros and cons of both approaches, this guide equips financial planners to address how strategic investment strategies can best align with their time horizons, risk tolerances, and financial goals.

Reach out today to learn how East Bay’s outsourced COI services can save time and help your practice grow.