Con: tactical asset allocation: a sure-fire investment technique or just a fad?

Tactical asset allocation: a sure-fire investment technique or just a fad?

A not-so-secret formula

Can you really make effective investment decisions using tactical asset allocation? This investment specialist thinks not, and says the Law of Large Numbers is what makes the technique look successful.

On a recent walk around our offices located next to Faneuil Hall in Boston, we found a T-shirt vendor, looking rather forlorn. He was literally giving away a truck-load of T-shirts with "Portfolio Insurance" inscribed across the chest. Asset managers sometimes do turn lead into gold, so we took his inventory and printed "Tactical Asset Allocation" on the backs of the shirts. Now, they're selling like hotcakes.

Indeed, tactical asset allocation (TAA) is very much like the flip side of portfolio insurance. One reason TAA is now such a hot topic is that it provides an answer to the ubiquitous question from senior management: "What are we doing to protect against another October 19 market decline?"

Tactical asset allocation vendors whose models reduced equity exposures to low levels before the October 19 decline are knocking on doors to sell their magic elixir. However, all TAA models aren't equally prescient. The following analogy may serve to put into perspective the offering of those who come marketing their wonder cures.

Imagine a room full of monkeys. Each of them participates in a game to try to predict the direction of the market. There are 1,000 monkeys in the room. At the end of 10 predictions, there is one monkey with a perfect record of 10 straight calls, 10 with nine out of 10 correct, and 44 with eight of 10 correct.

What happens next? The monkey with the perfect record starts his own investment firm. The monkeys with nine out of 10 correct calls get recruited by the larger investment firms who are eager to get into the tactical asset allocation game, and those with eight out of 10 are hired by those companies that can't afford the "top" talent. Eventually, all of these monkeys will knock on your door to market their impressive past deeds. The unlucky monkeys--the 945 with fewer than eight correct predictions--stay home.

However, there is now a new breed of monkey, even more clever. Rather than make predictions, these monkeys try to figure out a system to predict the market. After many, maybe thousands, of tries, they come up with a scheme that would have predicted the last 10 market moves correctly, or, if they are less ambitious, only nine of the last 10 market moves. We'll call them the rocket scientist monkeys; they also will knock on your door--with simulated results in hand. But do they really have a cure-all? Or are they selling something else, something the unlucky monkeys, who outnumber the lucky primates nearly 20 to one, didn't happen upon?

The Law of Large Numbers

Some ask if TAA isn't really just market timing. Market timing does reappear from time to time, usually under a new alias. It's been called balanced fund management, asset allocation, portfolio insurance, and now tactical asset allocation. Whenever someone attempts to shift money from one asset category to another, either in anticipation of future market moves or in reaction to past market moves, this is market timing.

Remember, however, a rose by any other name still has thorns. There is a big risk in market timing that is often overlooked. Market timing is an undiversified decision. You make only one decision at a time, and each is a big one. In addition, you don't have the opportunity to make very many decisions. There is a branch of mathematics that deals with this problem called the "Law of Large Numbers."

Baseball players are quite familiar with this law. Which batter would you prefer in a crucial situation: a pinch hitter who has a .400 average for 10 at bats, or Wade Boggs, who has a .359 average in 527 at bats? A good baseball player knows his skill as a batter is evident only over the entire course of the season. The more often he comes to bat, the more his skill will win out.

Investing follows the same law. The more independent decisions you make, the better chance your skill has to rise above the noise. And there's the rub with market timing. If you bat infrequently, it may take a long time before you can prove your skill.

As our T-shirts suggested, TAA is an opposite of portfolio insurance. Portfolio insurance is a buy high/sell low strategy, and TAA is a buy low/sell high strategy. Portfolio insurance wins in a consistently rising or falling market; tactical asset allocation wins in a volatile, trendless market. Some of the same people who were buying portfolio insurance are also buying tactical asset allocation. But if something is good for the goose, then how can the opposite also be good for the goose?

The astute observer will ask, what happens if everyone does tactical asset allocation? If everyone buys the market the second it drops (a simplified but defensible view of TAA), and sells it the second it rises, won't there be complete price stability? Of course there will be. But, in the long run, it will lead to inefficient capital formation. Underlying fundamentals do change, and prices should reflect this.

Deliberate decisions

The asset mix decision is the most important one the pension fund has to make. As much as 90 percent of the ultimate returns relate to asset categories rather than individual security selection. Shouldn't you then spend the majority of your time on these allocation issues?

There are two kinds of allocation issues. The first deals with your long-term exposures to the various asset categories. Determining how much should be allocated to stocks, bonds, and cash, for the long term, is important and worth the time and effort. This strategy will dominate any other decision you will make.

However, the practice of shifting your assets from asset category to asset category to reap short-term profits is another question altogether. The potential payoff to these tactical moves is compelling. However, lifetimes have been wasted in the pursuit of turning lead into gold. The secret formula always proves elusive. So don't waste much time on something that is difficult, if not entirely impossible, to do.

The bottom line is that markets may overreact in the short run. However, these opportunities will show up only once or twice every five years. Therefore, one needs to make decisions deliberately. Remember, you have to be above average to play the market timing game. Everyone is not above average, and if everybody plays the game, everybody can lose.

Also, a point to remember is that, with an increasing number of people essentially selling portfolio insurance (by buying tactical asset allocation), now may be an interesting time to be a buyer.

Is there any way to guarantee your timing of the market? There is one investment strategy that has maximized return over the long run with little or no turnover. It also has picked the best performing asset category, on a monthly basis, 58 per cent of the time over the last 55 years. The magic formula? Simply invest in equities all the time.