Mind over matter

Taking the emotions out of investing with tactical asset allocation

31 Jul 2019

Questions you can ask your UBS Financial Advisor

  • What can I do to help manage equity risk during market swings?
  • How can I fine-tune my long-term investment plan in response to broader market trends?
  • How can I capture upside potential in the markets while protecting my portfolio from downside risk?

Equity market volatility can be jarring for investors. But those who get spooked by it and let their emotions dictate their actions by pulling out of the market could miss out on potential opportunities. Tactical asset allocation is a solution that may help investors navigate this environment by actively managing equity risk during market swings.

A losing combination?

Investment wisdom tells us to buy low and sell high. But emotions often lead us to do the exact opposite—buying high and selling low. Most investors do not intentionally set out to buy high and sell low, yet during bull markets investors are optimistic, and they may fear “missing out” on potential gains, so they jump in. Conversely, during bear markets, pessimism takes hold and emotion can drive the decision to sell to avoid further losses.

So why do investors engage in such behavior? It’s really not their fault. Research into human behavior has shown that investors dislike losses twice as much as they like equivalent gains.1 The phenomenon even has a name: loss aversion, and could be the reason why investors have the irrational urge to hang on to losing stocks in the hope that the price will recover.2

Owning a diversified portfolio with a mix of asset classes that investors can stick with through a full market cycle (both a bull and a bear market) can help reduce their anxiety and curb irrational behavior. But even a diversified stock and bond portfolio can be dominated by equity risk. Consider that in a sample portfolio comprising 50% equities and 50% fixed income, equities can contribute over 90% of the volatility (risk) over the longer term. And it’s this volatility that can be so unsettling for investors, causing them to potentially make ill-timed decisions. While diversification remains a key investment principle, it may not always be enough. That’s why a tactical asset allocation strategy may be an appropriate complement to a traditionally diversified portfolio.

Algorithms don’t have emotions

What is tactical asset allocation and how can it help investors stick to their long-term goals? Tactical asset allocation strategies are intended to remove the emotional factor from the equation by relying on data and quantitative models (algorithms) to guide investment decisions and adapt to changing market conditions. Rather than periodically rebalancing to a pre-set allocation, such as a traditional 60/40 split between stocks and bonds, an investor can adjust their equity-risk exposure when markets are trending down and increase exposure when markets are trending up, striving to help manage losses during downturns in equities while potentially participating in gains.

Investors using a tactical asset allocation strategy have to be nimble and may have to change their investment approach to avoid perceived risks or to capitalize on evolving opportunities. Simply put: Tactical asset allocation strategies seek to capture the majority of the upside when times are good, but also to protect capital when times get bad. It’s this flexible nature that can potentially provide an extra layer of diversification to a traditional portfolio.

While diversification remains a key investment principle, it may not always be enough. That’s why a tactical asset allocation strategy may be an appropriate complement to a traditionally diversified portfolio.

Tactically speaking: How does tactical asset allocation work?

Tactical asset allocation strategies use quantitative models that evaluate a range of financial and economic information, such as US macroeconomic data and global corporate earnings, to assess market and economic conditions. The tactical asset allocation model uses this information to produce “signals” that are used to determine an appropriate level of equity exposure. A “positive signal” would indicate a favorable outlook for equities, when the equity market has a clearly advancing trend and while the economic outlook and earnings are improving. On the other hand, a “negative signal,” which represents an unclear or negative outlook for equities, is likely to be generated when the equity market is volatile or in a down trend and when economic fundamentals or earnings are worsening.

Based on these signals, an investor can make shifts in the portfolio attempting to capture upside potential, while offering downside protection. It is important to note, however, that tactical asset allocation is not the same thing as market timing. Rather it is a form of fine-tuning a portfolio for an established long-term master plan in response to broader market trends.

Getting tactical in your portfolio

A tactical asset allocation strategy is designed to provide downside protection and lower volatility, and help you focus less on daily market swings. When used to complement your traditional strategic asset allocation, a tactical asset allocation strategy can provide the potential for improved outcomes. Your UBS Financial Advisor can help you identify the strategy that best suits your individual investment needs.

Are you prepared for the changing investment landscape? Together we can find an answer. Connect with your UBS Financial Advisor or find one.