While adopting a tactical asset allocation might seem tempting during bouts of heightened volatility, the timing and skill required to perfectly execute a portfolio shift is near impossible. Sticking to a strategic asset allocation however is likely to yield better returns.
It is no surprise that the recent turbulence in financial markets has investors on edge. Interest rates have been rising amid higher inflation and for the first time in quite a while, many investors are facing losses in both the equity and bond sleeves of their portfolio. As a result, some investors are asking: what adjustments can I make to protect my portfolio from further rate rises, inflation and lower than anticipated growth, should that continue in the future?
Given the turbulence across asset classes in recent months, the idea of the traditional balanced portfolio, or one based on “strategic asset allocation” like the 60/40 portfolio, may seem antiquated. Ongoing market volatility might therefore prompt consideration of a switch towards a strategy that strives to take advantage of market trends or economic conditions by actively shifting a portfolio’s allocations - a “tactical asset allocation”.
But if we take stock of the long-term lessons from market history, investors who succumb to this temptation will probably end up making things worse, even though getting nimble with your portfolio sounds easy enough. This is because forecasting and executing with the precision required to successfully time the markets is notoriously hard.
It requires investors to be right on five accounts: identifying a reliable indicator of short-term future market returns, timing the exit of a specific asset class or market down to the precise day, timing re-entry into a specific asset class or market down to the precise day, deciding on the size of allocation and how to fund the trade, and then executing the trade at a cost that is lower than the expected benefit.
Not only would investors have to get it right on all five factors above, but they would have to demonstrate this extraordinary skill repeatedly. And while there are a handful of experts out there who can do it, for the vast majority of investors, it will certainly be a tough and ultimately unrewarding experience. Sage investor William Bernstein captures it nicely: “There are two kinds of investors, be they large or small: those who don’t know where the market is headed and those who don’t know that they don’t know.”
To underscore this and the modest rewards at stake from trying, Vanguard analysis using MSCI USA Index and the Bloomberg US Aggregate Bond data found that if investors successfully anticipated economic surprises 100 percent of the time, their annualised return over more than 25 years would only be 0.2 percentage points higher than a traditional balanced portfolio of 60% U.S. stocks and 40% U.S. bonds. An investor who was correct half the time—the equivalent of a coin toss or random chance—would have underperformed the base portfolio.
To further put this in the Australian context, there were more than 13,000 trading days on the ASX from 1972 to 2022. Out of those, missing the best 30 trading days would result in a 30% reduction in annualised returns for a local equity investor – from 10.8% to 7.3% – over the 50-year period. And to make things even trickier, almost half of these best trading days occurred within a week of the market’s worst days. This really brings home the point that not only is precise timing nearly impossible but also that being out of the market at the wrong time will cost you. Thus, practically speaking, when it comes to using tactical asset allocation in a bid to time the market, the only winning move for most of us is not to play.
Most of the financial headlines we read are rightly focused on the events of the day. But when it comes to your investment portfolio, today is not that important in the context of a 30–40-year investment horizon. Over the course of your lifetime, it is the asset allocation decisions you make and stick with that will drive your investment success. Using a strategic asset allocation may feel passive and boring but it works.
Assuming investors already have a diversified portfolio with an asset allocation appropriate for their own goals, time horizon, and risk tolerance, the best action in times like these is often confident inaction.
An iteration of this article was first published in the Australian Financial Review on 4 July 2022.