Is a Strategic Asset Allocation a Failed Model?

by KenFaulkenberry

in Asset Allocation

Strategic Asset Allocation
Strategic Asset Allocation

Most investors struggle with an asset allocation model that will optimize their risk and returns. Most, without even realizing it, implement a strategic asset allocation because it is the most often taught model by mainstream financial planners and the media. However, today there is a growing debate that is challenging this investment model.

What is a Strategic Asset Allocation?

Strategic asset allocation describes a model in which the portfolio mix of assets is fixed according to the individual investor’s profile. The percentage of assets allocated to cash, bonds, stocks, real estate, etc. is set according to the investor’s goals and strategies, current financial status, and risk tolerance.

The key supposition is the asset allocation remains fixed unless the investor’s profile changes. In other words, if the investor determines that 60% equities, 30% bonds, and 10% cash is their target asset allocation, then that will be the target unless there is a change in the investor’s goals and strategies, current financial status, or risk tolerance.

Advantages of a Strategic Asset Allocation Model

There are two main advantages of a Strategic Asset Allocation:

1.  Relatively easy to maintain.

2. Tailored to the individual investor’s profile.

With a strategic asset allocation the investor can invest on “auto pilot”. After the initial analysis that determines the investor’s goals and strategies, financial status, and risk tolerance, little effort is needed to maintain the set asset allocation.

Disadvantages of a Strategic Asset Allocation Model

This main disadvantage of a strategic asset allocation model is that it only considers the investor’s profile. The other half of the equation is the non-investor factors. The most important non-investor factor is the valuation of the opportunities available. This important factor is completely ignored by a strategic asset allocation model.

Would a Tactical Asset Allocation Strategy be Better?

I believe a tactical asset allocation strategy is best because it can adapt to both the investor’s profile and non-investor considerations such as valuations and intrinsic value . The irony of using this strategy is that it lowers risks and actually makes investor profile considerations less important. Regardless of investor’s profile; does it make sense for anyone to invest when the odds are poor?

We know from history that when you buy investment assets at high prices compared to their intrinsic value you will make below average rates of return in the long run. Conversely, when you buy investment assets that have low or reasonable values compared to their intrinsic value you can achieve higher than average rates of return in the long run.

Think about it, did it make sense to have the same allocation to equities in 2000 as it did in say March of 2009? A strategic asset allocation would have had the same percentage allocated to equities when they were selling at historically expensive prices compared to earnings as when they were selling at a fraction of those prices a few years later.

Do you think valuation should be considered in your portfolio asset allocation?

Related Reading: 5 Value Strategies For Asset Allocation

Investment Allocation – Implementing a Tactical Asset Allocation

Written by KenFaulkenberry

KenFaulkenberry

AAAMP Blog by Ken Faulkenberry
Ken Faulkenberry earned an MBA from the University of Southern California (USC) Marshall School of Business with an emphasis in investments. Ken has 25 years of investment experience and is dedicated to helping people with self-directed investment management through the Arbor Investment Planner. His asset allocation strategies have an outstanding performance record.
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John Marlowe

Thanks for this, Ken, as I feel that this is something VERY important that is often overlooked.

I have spent a good amount of time looking for the best asset allocation for myself, and this topic has been the major focus of my time. Though I do agree that valuations should dictate the MAJOR shifts in one’s asset allocation, this still ignores certain risks dependant on the individual.
Just as one would not want the same AA in 2000 as they would in 1982 or 2009, one would also not want the same AA when they are 20, 40, and 70. Major reasons include time in the market, time until retirement, and portfolio balance.

My solution to this is to have two separate ‘glide paths’ to come to my current desired AA – one based on age, the weighted average of my expected earnings, and modern portfolio theory – the other strictly based on the current valuation of the market. I give a 50% weighting to the Valuations curve and a 50% weighting to reduce risk using the other three factors.

I would like to see more on the topic – especially along the lines of the first paragraph in the section regarding the Tactical Asset Allocation. I agree that this substantially reduces risks, and I’m trying to dig into just by HOW MUCH these risks are reduced. I still don’t see evidence that one should ignore the possibility to reduce risks further – certainly valuations should not be the ONLY factor.

The main point of the article is very important, and I agree that this too is beginning to be disproved as the best way to do things. I look forward to more good discussion on the topic.

KenFaulkenberry

Thank you for your thoughtful comment John. I essentially agree with everything you said with a little more bent toward valuation than 50%. My belief is there should be no difference in AA for a 20 year old versus a 40 year old (everything else being equal). Both should be risk adverse when valuations are high and more aggressive when prices are bargains. A 70 year old might be somewhat different in that they may need more allocated to income and less to growth. But this would be dependent upon there individual needs including the size of their portfolio compared to living expenses. Otherwise, even a 70 year old should have a similiar risk profile to a 20 or 40 year old because all of them should should invest conservatively when valuations are high. One of my arguments is that most investors are too aggressive. It is the 20 year old that has been told to invest aggressively (regardless of valuation); and I believe this is bad advice. Thank again John!

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Tactical asset allocation essentially takes a strategic asset allocation and regularly adjusts it for changing market conditions subject to forecasts, whims or guesses. The premise is that by doing this, one can optimize market exposure to best maximize risk-adjusted returns. It relies on forecasting skill and adroit execution. Let’s assume that you are an investor who, on December 31, 2007, had a portfolio that stood at 80% equities and 20% fixed income. There were no withdrawals from this portfolio and no cash inflows. By the end of 2008, your portfolio was probably closer to 60% equities and 40% fixed income due the dramatic decline of equity prices throughout the year. If the strategic asset allocation target called for an 80% equity/20% fixed income ratio, then, under the guidelines for strategic asset allocation, the investor would rebalance the portfolio to the policy asset allocation of 80% equities and 20% fixed income by selling fixed income and using those funds to buy equities. However, if an investor was practicing tactical asset allocation, they might decide that the market recovery will be strong and they wish to temporarily move the equity allocation to 90%. Hopefully, the investor or investment manager has some preset parameters to judge whether or not he is right and when to go back to the long term strategic allocation. Portfolios utilizing tactical asset allocation are exposed to two primary performance drags: inaccurate forecasts (i.e. bad market calls) and trading costs.

KenFaulkenberry

A tactical asset allocation used correctly is not based on “forecasts” but on valuations. Thank you for your comment.

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As far as the value of tactical asset allocation who knows. I would like to suggest a simple way of investing in exchange traded funds and closed end funds that can greatly increase returns while at the same time lower risk. I believe this method because of its simplicity can enable even those with limted financial knowledge to become rich with considerable less risk.
Anyone that has any doubts as to the Accuracy and validity of the information provided below feel free to check it out with any competent financial advisor. I feel totally confident that my analysis will withstand any serious security.
Im am speaking about exchange traded funds and closed end funds from the perspective of a citizen of the united states. The following may not apply to investors worldwide.
Their are now over fifty single country funds available and maybe over 100 narrow sectors like airlines steel solar so why the concern for the nasdaq or the standard and poor five hunderd each one of these countries and sectors is a index of and by itself The solar exchange traded fund {TAN} is now down 90% from its high in 2007. If I were a investor or trader I would simply look for any exchange traded fund or closed end fund that does not use any leverage in their porfolios and start buying in the ratio of 0.50 percent of your cash on hand in my account after their is a 75% decline from its all time high and than buy twice as much in the ratio of 1.00 percent of your cash on hand in my account if that exchange traded fund or closed end fund declines another five percent an 80% decline from its all time high buy twice as much in the ratio of 2.00 percent of your cash on hand in my account at a 85% decline from its all time high buy twice as much in the ratio of 4.00 percent of your cash on hand in my account at a 90% decline from its all time high and finally buy twice as much in the ratio of 8.00 percent of your cash on hand in my account at a 95% decline from its all time high. Now I know that some of these funds will not decline 90% from their all time highs. Another thing that you might be wondering about I would run out of money. If I followed that method right wrong example take one hundred thousand dollars. Example Buy 500 dollars of xyz fund at 25 dollars off 75% from its all time high of 100 dollars buy 1000 dollars of xyz at 20 dollars off 80% from its all time high of 100 dollars. Buy 2000 dollars of xyz at 15 dollars off 85% from its all time high of 100 dollars Buy 4000 dollars of xyz at 10 dollars off 90% from its all time high and finally Buy 8000 dollars of xyz at 5 dollars off 95% from its all time high This way you will have your biggest positions in the funds that have declined the most and the smallest positions in the funds that have declined the least. Also keep in mind that if your cash position in your account is say one hundred thousand dollars to start this will gradually decrease as the equity portion of your portfolio increases. Example If your cash position is fifty thousand dollars of your one hundred thousand dollar portfolio you would invest one half of one percent to start which would be two hundred and fifty dollars. Also keep in mind when you buy an exchange traded fund you are buying a basket of stocks so the fund cannot go to zero unlike a stock. Than when any fund has regained three quarters of its value that would be say fund XYZ which traded at 100 dollars five years ago. It now trades at 75 dollars in the case of XYZ. Now you would use a 15% trailing stop loss to protect your gains. So if XYZ declines to 63.75 from 75.00 you would be stopped out insuring that you retain most of your gains. If XYZ continues to rally without correcting by 15%. Who knows you may sell out of the stock within 85% of its all time high. Its all time high could be 150 dollars..
And their you have it a simple but brilliant strategy for exchange traded fund and closed end fund

KenFaulkenberry

You are describing a version of a tactical asset allocation. The problem I have with your concept is that it does not directly take into account valuation. Just because an individual ETF is down 75% it does not mean there is value. Maybe the fund is full of overvalued stocks eventhough it is down 75%. Although I use ETFs in the AAAMP (about 80% stocks, and 20% ETFs) they have a critical flaw. They are index funds so you own both the good and the bad in the fund. Most ETFs will have both undervalued stocks and overvalued stocks in their portfolio because most replicate an index and do not use a value approach.

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