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.