Tactical asset allocation: Fine tuning a longer term strategy

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Setting percentage limits on allocation shifts and time limits on maintaining these shifts can help to limit risk.
Strategic asset allocation, the practice of maintaining a strategic mix of stocks, bonds, and cash, has guided many investors in creating portfolios that suit their risk profile and long-term investing goals.Footnote 1 This widely used strategy is a long-term, relatively static tool and is not intended to take advantage of short-term market opportunities.
Proponents of tactical asset allocation (TAA), in contrast, take a shorter-term view. TAA is the practice of shifting an asset allocation by relatively small amounts (typically 5% or 10%) to capitalize on economic or market conditions that may offer near-term opportunities. TAA differs from rebalancing, which involves periodic adjustments to your strategic allocation as a result of portfolio drift or a change in personal circumstances. With tactical asset allocation, you maintain a strategic allocation target, but fine tune the exact mix based on expectations of what you believe will happen in the financial markets.

Assessing risk and return

For example, suppose an investor started with an initial target mix of 50% stocks and 50% bonds on January 1, 2017. Believing that the stock market was undervalued and a recovery was in sight, the investor switched the allocation to 70% stocks and 30% bonds on that date. Between the date of the allocation change and December 31, 2017, the revised 70/30 allocation would have generated a return of 16.34% compared with the 50/50 allocation, which would have returned 12.69%.Footnote 2
Tactical asset allocation also can work on the downside. For example, suppose a hypothetical investor, sensing trouble in the financial markets in light of the credit crisis, reduced an initial allocation of 60% stocks/40% bonds to 50% stocks/50% bonds on October 1, 2007. Between the date of the allocation change and May 1, 2008, the 50/50 allocation would have generated a return of -1.6%, compared with a return of -2.9% for the original 60/40 mix.Footnote 2

Within an asset class

TAA also can involve shifting allocations within an asset class. For example, an equity portion of a portfolio may be shifted to include more small-cap stocks, more large-cap stocks, or other areas where an investor perceives a short-term opportunity.Footnote 3 Note that mutual funds that invest in these areas may impose restrictions on short-term trading, and it is important to understand these restrictions before making an investment.
A tactical approach involves making a judgment call on where you think the economy and the financial markets may be headed. Accordingly, a tactical allocation strategy can increase portfolio risk, especially if tactical allocations emphasize riskier asset classes. This is why it may be a good idea to set percentage limits on allocation shifts and time limits on how long you want to keep these shifts in place.
In addition, when evaluating investment gains that are short-term in nature, such as those on investments held for one year or less, it is important to understand taxes on short-term capital gains. Currently, short-term capital gains are taxed as ordinary income, where the highest marginal tax rate is 37% (plus a potential 3.8% net investment income tax). In contrast, long-term capital gains on investments held for more than one year are taxed at 15% for most taxpayers, 20% for those in the highest tax bracket (plus a potential 3.8% net investment income tax).Footnote 4

Asset allocation, diversification, and rebalancing do not ensure a profit or protect against loss in declining markets.
Footnote 2 Source: SS&C Technologies, Inc. Stocks are represented by the total return of the S&P 500, bonds by the return of the Barclays U.S. Aggregate Bond Index. Investing in stocks involves risk, including loss of principal. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values are subject to availability and change in price. It is not possible to invest directly in an index. Past performance does not guarantee future results.

Footnote 3 Securities of smaller companies may be more volatile than those of larger companies. The illiquidity of the small-cap market may adversely affect the value of these investments.

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The material was authored by a third party, DST Retirement Solutions, LLC, an SS&C company ("SS&C"), not affiliated with Merrill or any of its affiliates and is for information and educational purposes only. The opinions and views expressed do not necessarily reflect the opinions and views of Merrill or any of its affiliates. Any assumptions, opinions and estimates are as of the date of this material and are subject to change without notice. Past performance does not guarantee future results. The information contained in this material does not constitute advice on the tax consequences of making any particular investment decision. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security, financial instrument, or strategy. Before acting on any recommendation in this material, you should consider whether it is in your best interest based on your particular circumstances and, if necessary, seek professional advice.

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