Tactical asset allocation (TAA) starts with a highly-diversified asset allocation, of the kind inspired by Harry Browne’s Permanent Portfolio (1/4 each in stocks, bills, bonds, and gold). We’ll do better later by adding additional asset classes, but even this simple portfolio provides a foundation that is robust across changing investment conditions (boom, bust, inflation, deflation).
Below we see the Permanent Portfolio (Portfolio 1) vs a traditional portfolio of 60% S&P500 and 40% 10-Year Treasuries from 1930 through 2016. Returns are rarely very high, but never very bad. It was down just 4% for the year in 2008 and its highest ever drawdown was 28% in the depths of the Great Depression, compared to 60% for the traditional portfolio (stocks alone fell 89%).
All calculations and charts are from Portfolio Visualizer
Now, let’s get tactical. We’ll apply a simple moving average (SMA) filter to each of the four asset classes, a kind of stop-loss. For each asset, we’ll take the average monthly close over the last X months (here we’ll use 10 months, though anything from 6-15 will work). Every month we check to see if that asset is above its SMA, and if it isn’t we take that 25% of the portfolio and put it in 10-year Treasury notes. As you can see, this dramatically reduces the downside volatility. It also increases the long-term return, since the portfolio (“Timing Portfolio” below) is never in the red for very long:
We’re still lagging the traditional portfolio over the long-term, because its 60% stock allocation can really rip during bull markets. The next step makes up for that. Every month we not only apply the SMA filter, but we concentrate our portfolio into the top two performers in recent months. For example, if stocks and gold are leading bonds and bills, we’re 50% in stocks and 50% in gold. Now our best year and overall return exceed that of the traditional portfolio, with less than half the downside volatility:
The above is an incredibly elegant strategy that has stayed out of trouble during the Great Depression, the 1970s, the dot-com bust, and many other nasty bear markets. It was even up 19% in 2008.
With today’s low-cost ETF offerings it’s easy to diversify beyond four asset classes, so let’s see what happens when we add smallcaps, foreign stocks, corporate bonds, and mid-duration bonds and hold the top four of eight:
This is just an illustration of TAA, but covers all the basics of what we do for real. To be fair, we’ll need to add a provision for fees and trading costs, so below is what this equity curve might look like with a realistic 1% management fee and 0.5% in commissions & ETF fees. Costs would have been much higher before the era of discount brokerages.
The basic steps above can result in outstanding risk-adjusted performance, as measured by Sharpe and Sortino ratios. I believe that this is far and away the best single approach to long-term investing, since it generates the most consistent returns throughout a variety of market conditions. A certain value investing approach can generate good risk-adjusted returns as well, but it can be very frustrating at times like today when stocks are overvalued and keep going higher while you sit in bonds. Like such a conservative value approach, the caveat with TAA is that it won’t do as well as stocks when stocks are in a roaring bull market. That’s a small price to pay for better long-term returns with far less heartburn.
Credits: All calculations and charts are provided by Portfolio Visualizer.