I'm writing this a little bit late — maybe seven years too late. It was after the financial crisis that "tactical asset allocation" came into vogue. The buzzword, and the idea itself, are still very popular.
Tactical asset allocation is a fancy way of saying market-timing. When you think it's a bull market, you hold more stocks; when you think it's a bear market, you hold more cash. Everyone would like to do that, right? You buy when things are going to go up and sell when things are going to go down, and you make a bunch of money.
The trick, of course, is getting the timing right. If you bet that we were still in a bull market in October 2007, you got caught in the crash. But if you bet that the downturn in September 2011 was the start of a bear market, you missed the boom that followed. Of course, you can be cautious or aggressive with market timing — you can slightly shift your allocations, or you can try to go for the big short. But the greater the potential reward from picking market shifts, the greater the risk.
The interesting questions with regard to tactical asset allocation are: 1) Can it really work for asset managers? 2) Should investors buy into it? And 3) How does it affect the market?
Economists have studied all three of these questions. Surprisingly, the answer is that tactical strategies can work, both for managers and investors, but that in doing so they probably make the market more volatile and inefficient.
Why can tactical strategies work? Because returns in most asset markets are predictable. This was first noticed — in academia, at least — by Robert Shiller in the early 1980s, but by now it's common knowledge. Measures of fundamentals, like dividend yields, predict stock performance. Bond prices are predictable too. When assets look expensive relative to their historical fundamentals, it's a sign that a bear market is coming. And since lots of other things in the market and the economy are correlated with stock and bond fundamentals, there are any number of signals out there that could give people useful information about how to time the market.
Of course, there are caveats. The predictability is there, but it isn't very strong — the boost to returns from market-timing strategies just isn't that big. It also takes years for the effect to kick in, meaning that if your performance is measured annually, there's a good chance your far-sightedness won't be reflected. Still, tactical strategies can boost an asset manager's returns if used correctly.
