Note: This article appears on the ETFtrends.com Strategist Channel
By Bryan Novak
The last two years have done little to instill investor confidence, and the past nine months have likely made the situation worse. To be sure, the most recent survey by AAII (American Association of Individual Investors) shows the % bullish levels similar to when the markets were near their lows in February. According to a recent study by State Street, investors continue to be wary about reinvesting in the market as show by cash holdings of nearly 40% in their portfolios. The fact even small dips make big headlines is not helping to calm nerves either. Of course, when the end goal is return, abandoning a long-term game plan is not an effective way to combat risk and volatility. So what are the options? I believe tactical asset allocation strategies can provide a solution for risk management. Combining a tactical strategy with a traditionally allocated portfolio is a way an investor can address risk concerns, help achieve long-term growth, and even calm nerves along the way.
If you’re not familiar with tactical asset allocation, it is a type of strategy that has been used for decades to manage portfolio risk exposure by adjusting asset allocations based on a defined set of criteria. The criteria will dictate both a portfolio’s response to market conditions and therefore attempt to accomplish a specific outcome. Generally speaking, the primary goals for tactical strategies are to 1) reduce portfolio volatility when warranted and 2) by doing so, to reduce participation in substantial drawdowns such as what was experienced in 2008.
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To achieve these goals (which it is important to note may differ), market price is often be used as a “trigger” for change. Weakening or strengthening price trends may guide investment decisions. In this discipline, the decision tree is often somewhat binomial, as a price is either above or below another price. To smooth out the signal and integrate a larger data set, multiple time series can be blended together. Either way, the input can be impacted by volatile short-term market activity which may subject a portfolio to frequent signal flipping. In recent months, many strategies using price inputs have likely been whipsawed by the short-term fluctuations of the broad equity markets.
A separate and distinct way to manage portfolios is to focus on macro (or fundamental) trend indicators—rather than market price—as the trigger for adjusting positions. Think of it as focusing on the “why” behind the market movement as economic growth is closely correlated to financial market direction. By comparing current values of a data point to a defined historical period, an investor can see which direction the data is trending (there are obviously no assurances that trends can or will be duplicated in the future). Aggregating multiple key data sets of economic reports in this way can build out a broader picture of the economy.
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