July 25th 2011: Why Tactical Asset Allocation

07/25/2011 Share 0 comments

In this newsletter, we first answer an easier question: why Tactical Asset Allocation (TAA)?

In our previous newsletters, we introduced SAA (Strategic Asset Allocation) that is based on mainstream portfolio theory and widely practiced in professional asset managers. The strategy is the foundation of portfolio building, especially its asset class and diversification concept. However, the question arises: is this enough?

Let's take a look at how SAA performed in the previous two bear markets. The following shows how six core asset SAA, three core asset SAA, VBINX (Vanguard balanced fund index, 60% stocks/40% bonds) and VFINX (Vanguard 500 Index) did in 2001, 2002 and 2008.

See here for more detailed comparison.

It is clear that diversification does help but losing a quarter of your portfolio is one year is not a light matter, in fact, it is quite detrimental to many retirement accounts.

SAA is based on a crucial assumption: in the long run, major assets such as stocks, REITs and commodities will go up. Can one simply trust this? Furthermore, how long is the long run?

For U.S. stocks, we quote the following from our recent article:

Here are some key points cited by Marketwatch.com's Howard Gold from his interviews with the authors (two professors who wrote a paper Are Stocks Really Less Volatile in the Long Run?):

• There have been periods in which stocks underperformed [Treasury] bonds and bills over 30 years, [and] 40-year periods in which stocks barely [outperformed] bonds.
• Even with 200 years of stock data (Dow Jones Industrial Index (DJI) and S&P 500 (SPY))  supporting Siegel's claim, the U.S. faces a lot of uncertainty. The past 200 years have been very kind to the U.S., [but] there's some probability you might lose a war. There's some probability you might have a financial meltdown. There's no guarantee we're going to bounce back.

As what we stated in our recent newsletter, the intuition behind holding U.S. stocks for a long run is that if you are certain that in the long run, the U.S. economy will be resilient and prosperous. The problem here is what it means for 'the long run'. Is that 100 or 200 years? Or is that 10 or 20 years? For the very very long run, in theory, this author personally believes that the U.S. political and economic systems are still the best among the world and thus it is highly possible for the economy to do well. But for the coming 10 or 20 years?

For an average person, 10 or 20 years is a long time. In 10 or 20 years, our children will graduate from college, we will retire or might have enjoyed our retirement for a while (assuming we properly manage our health and finance), ... etc.. For such a "long term", it is even more important to take care of your own retirement portfolios by using the right strategies.

Well, it is simple to answer that why we need an alternative to SAA. But the much harder question is what kind of strategies? In the follow up newsletters, we will attempt to answer this.

Market Overview

Last week saw a big hurry to chase risk assets:

• All risk assets rose substantially, with international developed market stocks (European stocks) rose most.
• Gold and REITs are still solidly in the top two spots.
• Among all the major asset classes monitored, only treasury bonds and bills lost.

We are still at a tricky spot: with U.S. debt ceiling talk breaking down, we'll see how markets are going to react.

For more information on how these assets are ranked, please see here. 

Benchmark Portfolios

Our Retirement Income ETFs model portfolios have been steady this year. The following shows the performance of the two model portfolios

Portfolio Performance Comparison

Year to date, SAA 6.59%, TAA 5.22%, compared with VBINX's 6.42% and VFINX 8% respectively. We expect these portfolios will be resilient in the coming years as dividends will be a good cushion to the volatile markets driven by the economy that muddles along.

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How can we improve this newsletter -- we value your inputs --Thanks to those who have already contributed -- we appreciate it.

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