Evaluation of Customers - Strategic vs. Tactical Asset Allocation

  • Strategic asset allocation calls for setting target allocations and then periodically rebalancing the portfolio back to those targets as investment returns skew the original asset allocation percentages. The concept is akin to a "buy and hold" strategy, rather than an active trading approach. Of course, the strategic asset allocation targets may change over time as the client's goals and needs change and as the time horizon for major events such as retirement and college funding grow shorter.
     
  • Tactical asset allocation allows for a range of percentages in each asset class (such as Stocks = 40-50%). These are minimum and maximum acceptable percentages that permit the IA to take advantage of market conditions within these parameters. Thus, a minor form of market timing is possible, since the investor can move to the higher end of the range when stocks are expected to do better and to the lower end when the economic outlook is bleak.
Look Out!
On the test, strategic asset allocation may be linked with a "passive" investment style (see the Portfolio Styles section below), while tactical asset allocation is linked with an active" investment style.

Diversification
Once the target asset allocation percentages have been defined, the next step is to diversify. For example, within the bond or fixed-income class, investment options include corporate bonds, government bonds, municipal bonds, and so on. Further choices within the corporate bond category alone include short-term vs. long-term, investment-grade vs. high-yield (or junk) bonds, convertible, etc.

The range of options for stocks or stock funds is even wider. The information below refers to both individual stocks and mutual funds:

  • Market capitalization - market cap simply refers to the value of all of a company's outstanding common shares times the current market price. Stocks are classified based on size as follows:
    • Large-cap stocks $5 billion or more
    • Mid-cap stocks $1 billion - $5 billion
    • Small-cap stocks less than $1 billion
    • Micro-cap stocks less than $50 million
Diversifying across stocks with different market capitalizations is recommended. Typically, a larger allocation is made to large-cap stocks and smaller percentages to small-cap or mid-cap stocks.
  • Growth vs. value - stocks also differ by style. Typically, stocks (and mutual funds) are categorized as either growth or value oriented. Both styles have advocates who believe one is likely to outperform the other for different reasons.
    • Growth stocks are those whose earnings have been higher than average in the past and are expected to continue at a higher than average rate in the future. They typically pay low or no dividends and often trade at high P/E ratios. They tend to do well when the overall market is rising.
       
    • Value stocks generally have a strong balance sheet and higher dividends and are undervalued in the market given their earnings and asset values. Value stocks tend to outperform growth stocks during a falling market.

As in other contexts, diversification helps to reduce risk in a portfolio. Since different types of stocks have different characteristics, their rates of return will differ throughout the economic cycle. For example, if a portfolio is composed of 50% stocks, and a large-cap stock fund is the only investment, it may perform better during a downturn in the market than a small-cap fund, but the small-cap may outperform the large-cap during a market rally.

Portfolio Styles - Active vs. Passive


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