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Tactical asset allocation and market timing

The best individual financial planning and investment rules and practices are enduring and should not change due to market cycles or a financial crisis.

This article looks at asset allocation strategy in light of the recent credit crisis. The credit crisis was a systemic, global financial event that affected any financial or securities instrument influenced by debt and borrower credit worthiness. In short, the credit crisis affected everything.

During the credit crunch, many investors sought liquidity at the same time, because they either had to do so to meet their cash flow obligations and/or they feared greater losses and sought “safer” places for their money. Presto — the result was a global valuation downdraft that affected all asset classes. While some — but not all — classes of bonds did better relative to other asset classes, the real beneficiaries were those who already held bond positions before broader groups of investors got into a panic.

Whenever you are already there and invested in an asset class, it is more likely that you are already following a passive asset allocation strategy. While tactical asset allocation strategy advocates will suggest that you can anticipate the crowd and take action, these assertions not verified by studies of flows-of-funds into and out of investment mutual funds.

While a very, very narrow segment of investors might have some skill in anticipating trends and can actively pre-position their investments relative to the movement of the crowds, most people already have their money invested in an asset class, because they have chosen strategically to be invested in that asset class for the long-term as a buy-and-hold investor. Flow-of-funds studies show that almost all tactical asset allocation fund flows are late money flows that chase performance after valuations have already moved. On average, this tactical asset allocation money is late money and these investors get inferior returns.

At the end of the first decade of the new millennium, huge cash flows into bond funds still continued relative to flows into other asset classes, such as stocks. This is a trend that was almost three years in the making. We have not seen similar disproportionate fund flows into bonds since the 1984 to 1987 period, when interest rates were much higher than today’s paltry yields. In succession during the past decade, we have experienced a technology bubble market crash, a housing bubble crash, a credit crunch, and a resulting global economic/business cycle crash. Barring a total global economic depression, which we seem to have skirted and avoided, what will happen to the bond markets when interest rates inevitably rise? Stay tuned for whether bonds are the next sector bubble crash.

Recently, there has been more advocacy of “tactical” asset allocation strategies by certain financial advisors.

The logic goes as follows. Broad passively-managed asset class diversification strategies seemingly did not work during the credit crisis. Even broadly diversified investor portfolios went down, although not as much as portfolios that were more exposed to particular asset classes that had suffered the worst percentage declines. Therefore, buy-and-hold strategic asset allocation apparently did not work and should be thrown out. As a replacement, these financial advisors advocate that it is time to employ tactical asset allocation strategies that “could” get better risk-adjusted portfolio returns in the future. You know, start moving things around to get ahead of the crowd and be there before the crowd arrives to drive up valuations.

Unfortunately, tactical asset allocation strategy advocates do not offer anything to back up their claims that tactical investment activity will actually be superior to a passive asset allocation strategy in the future. Tactical asset allocation strategies have not been superior in the past. Advocacy for tactical asset allocation strategies flies in the face of the broad body of investment research. This research has consistently shown that low-cost, broadly diversified, passive buy-and-hold asset allocation strategies tend to yield superior long-term risk-adjusted portfolio returns.

Broad portfolio diversification has never meant that a portfolio could not and would not experience short-term losses at the portfolio level.

When you have an investment banking industry that finds clever ways to repackage smelly sub-prime mortgages as gilt-edged, investment grade derivative mortgage securities and resells these stinkers in vast quantities to other “smart money” financial professionals across the banking and investment world, then we just might all have a problem. When doing this over and over gets a lot of clever investment banking types some very large bonuses, then there is a lot of motivation to keep that gravy train moving along.

While you might question the ethics of these clever investment bankers, you should not forget that they sold these toxic mortgage securities to other willing professional buyers in the global banking industry. Those professional banker purchasers, in turn, tucked these gilt-edged derivative securities into their banks’ capital asset portfolios — the very capital portfolios upon which the banks ran their leveraged loan operations. When the music stopped and all the emperors had no clothes, bank capital evaporated and so did their ability and willingness to make loans. Of course, this was all compounded by tens of trillions of dollars in CDOs (credit default obligation swaps) that tried to pass the buck on the ultimate repayment responsibility for bad debts. Hot potato. Hot potato. But, wasn’t that a golden potato just yesterday? Did the investment bankers also make some sweet bonuses on the multi-trillion dollar CDO swaps market? You betcha!

Without your taxpayer dollars via the TARP bank bailout, the US and the rest of the world would all be in the financial black hole of a long-term global financial depression. In that event, most people would not have had to worry about short-term paper losses on their investment portfolios. Instead, many would have liquidated their portfolio holdings at cents on the dollar to meet living expenses after their jobs vanished.

If you have been following the chatter, you might remember hearing that most TARP funds have been paid back and some TARP loans to the banking industry have been reasonably profitable. Of course, this supposed profitability is only positive from a very narrow perspective. Taxpayers are not normally in the business of making bailout loans to the financial industry. While unfortunately necessary, it is difficult to argue that TARP loans were profitable to taxpayers, when you consider the vast global economic destruction that resulted; the job losses and the millions unemployed and under-employed; and the un-reimbursed hole that many still have in their personal investment portfolios.

So, when a huge and systemic toxic asset problem exists in the financial system, and the credit house of cards begins to fall, why would or should a diversified strategic asset allocation strategy prevent a short-term loss at the portfolio level? Moreover, why would tactical asset allocation be a superior replacement strategy? To the contrary, higher cost, less diversified, active investment strategies will do what they always do, which is lead on average to inferior risk-adjusted returns at the portfolio level. Even in a dire financial crisis, you should not lose sight of the long-term and forget the lessons of financial history. Broadly diversified, passive, low-cost, buy-and-hold strategies have been superior in the past, and they are much more likely to beat tactical asset allocation strategies in the future.

Tactical asset allocation and market timing
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