Strategic vs. Tactical Investments
De-risking (tactically repositioning a portfolio allocation below its strategic/target allocation weights) your asset allocation ahead of an economic pullback like a recession can be beneficial to your overall portfolio, but how do you go about doing that? Unfortunately, the media (TV, movies, etc.) makes us believe that investing is an all or nothing decision.
If we could predict the future and could say with certainty when a recession might begin, then selling all our stocks and going to 100% cash (or 100% short the market) would make a lot of sense. However, if we possess the ability to predict recessions before they occur, there's a high chance there are others out there that can also predict recessions, and they will also be trying to get out of risk assets leading up to the recession too. So to actually realize any benefits from our move to 100% cash, we would need to first predict the recession and then also predict when other market participants will sell all their risk assets and go to 100% cash.
This process of predicting how others will react is what the famous economist John Maynard Keynes referred to as the "beauty contest" of trading. Keynes said that being a successful trader was not about predicting events but how other people will respond to the events. This type of activity can yield enormous profits (and losses) and is generally reserved for speculators. While this activity is fine for traders and speculators, it is not appropriate for your hard-earned savings and retirement funds.
As investors, we need to differentiate between strategic allocations (strategy) and tactical allocations (tactics), two concepts often intertwined. A strategic allocation is the long-term plan that is fleshed out with your Financial Advisor and our planning team. The strategy guides the overall path. The tactical allocation is how we implement the strategy and how we might deviate from it (if at all).
The strategic allocation is usually an asset allocation based off an investor's ability and willingness to take risk. The appropriate strategic allocation describes how the investor will divide funds between various asset classes such as stocks, bonds, and cash. The strategic allocation can be based on goals or circumstances such as age and risk tolerance. The important thing to remember about the strategic allocation is that it should remain in place, unchanged, unless the original strategic allocation was incorrect or goals and circumstances have changed. Moving from strategy to strategy ultimately means there is no strategy.
The tactical allocation describes how you implement and execute your strategic allocation. If after meeting with your Financial Advisor your strategic allocation calls for 60% to be allocated to equities, you still have to figure out which type of equities to allocate to (small cap, large cap, international). Those are tactical decisions that are discussed quarterly with our Investment Committee. In extraordinary situations, tactical allocations will dictate a short-term deviation from the strategic allocation. A recession in the next six months would definitely warrant a tactical shift in your overall portfolio.
If your strategic allocation calls for a balanced strategy of 60% equities and 40% bonds and indicators start pointing to an imminent recession, you would tactically move that allocation to 50% equities and 50% bonds or 40% equities and 60% bonds. What we should not do is tactically take that portfolio to 0% equities. History tells us that even with massive amounts of data and the best economic research, there is a significant probability you will be wrong. We want to invest based on the probability of outcomes, not binary outcomes (yes recession or no recession).
Tactical allocations are very difficult to execute successfully, so the sheer number of tactical changes are often limited. Consider the following: if you are successful in reducing equity exposure prior to a recession, you still have to decide when to put that money back to work in equities. There's a sell and a buy that you need to get right. Are you willing to buy equities when the economic outlook is the darkest?
Since the tactical efforts are the most challenging, most of your efforts are focused on developing and building out your strategic allocation. The short-term zigs and zags of markets get a lot of attention, but it is mostly just noise and should not impact your strategic allocation. Your strategic allocation needs to be one you can stick with even if we head into a recession.
For example, if a future bear market ends up being as bad as some historic bear markets (2008) and stocks draw down 50%, how large of a hit will that be to your portfolio? If you are allocated in a balanced strategy, then you can assume a roughly 30% drawdown (60% equities x 50% drawdown). If you have a $1,000,000 portfolio, that's a $300,000 drawdown. How would you react to those type of losses? Would you sell out at the bottom? Does a loss like this have an impact on your retirement date or other goals? Would it impact your day-to-day life?
The tactical allocation garners the majority of people's attention for obvious reasons — it's more exciting to debate when the next recession will hit versus what should comprise the strategic allocation. But the strategic allocation is typically more important than predicting the next recession. It isn’t easy and there will always be uncertainties, but it isn’t nearly as hard as predicting the future.
