Wednesday, February 18, 2015

Tactical Asset Allocation And a Positive Investor Experience

When doing any type of analysis it is always easier if your variables are static.  However, in real life most things are rarely static.  Take traditional risk tolerance and suitability for example.   In a buy and hold, asset allocation world a client would walk into an adviser's office and complete some sort of risk tolerance questionnaire that would place them in either a conservative, moderate, or aggressive category.  The adviser would then construct a portfolio based on the client's risk tolerance.  So for example, a client with a moderate risk tolerance might have a portfolio that is 60% stocks and 40% bonds.  In an up market they would get about 60% of the upside of the market and in a down market they would get about 60% of the downside.   If the investor was moderate all the time then this would probably work out ok, they would be satisfied with 60% market upside and would be ok with 60% market downside.  However, in real life risk tolerance is not static.  Investors by and large want relative returns in an up market and absolute returns in a down market.  Or said another way, in an up market an investor's benchmark is the S&P 500 and in a down market it is T Bills.  This moderate investor would be calling their adviser during a bull market looking for more exposure to gains and during a bear market looking for less exposure to losses.   Buy and hold has no answer to this except to tell the investor during the bull market that they can't have the gains and to tell them during the bear market that they have to have the losses.  This results in a poor investor experience.

Investor Experience

Advisers should strive to create the best possible investor experience for clients.  Investor experience encompasses risk tolerance, but it goes beyond that.  It is giving the investor the most return possible as an end result and making sure that they can tolerate the ride.  Too much risk and they will panic at some point.  Too little return and they will not be happy.  Because your moderate client is really looking for relative returns in an up market and absolute returns in a down market they will eventually have a poor investor experience, either by not making enough in an up market or losing too much in a down market.  

Tactical Asset Allocation as the Solution

Not only does your client's risk tolerance shift with the market, it should.  An aggressive investor shouldn't be aggressive during a 2008 type of market and a conservative investor shouldn't be conservative during a 2013 type of market.  In 2008 there was a ton of potential risk and not much potential return in the market.  In 2013 there was a ton of potential return and not much potential risk.  Tactical asset allocation (TAA) can be perfect for optimizing the investor experience by shifting allocations based on the risk and return in the market.  In an up market an investor who is moderate in the base case might move to moderate aggressive.  In a down market that same investor might move to moderate conservative or conservative.  TAA would be shifting the portfolio at the same time the investor's risk tolerance was shifting.  

Looking at investor experience, the more conservative investor judges investor experience by looking at volatility and drawdown first and return second.  The aggressive investors judges investor experience by looking at returns first and drawdown and volatility second.  Tactical asset allocation can provide drawdowns and volatility that would be acceptable for more conservative investors while providing return potential that would be acceptable for more aggressive investors.  

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