Passive vs. Active Management (Strategic vs. Tactical Allocation)
Investing is a crucial part of financial planning, and the strategy you use to invest can significantly impact your long-term financial goals.
Passive and active management are two different investment strategies that market participants can choose to adopt.
Passive management involves buying and holding a diversified portfolio of securities that track an index, while active management involves actively trading securities and assets to beat the market.
Passive management is generally taken to mean the same thing as strategic asset allocation. It is more of a pure investor’s approach.
Activement management generally means the same thing as tactical asset allocation. It can be part of either an investing and trading approach.
Strategic allocation involves creating a long-term investment plan that is based on a specific asset allocation strategy.
This strategy is typically adjusted periodically to rebalance the portfolio and maintain the desired asset allocation.
On the other hand, tactical allocation involves making short-term adjustments to the portfolio based on changes in market conditions or the outlook for specific asset classes.
This approach aims to take advantage of market inefficiencies and generate alpha, which is the measure of performance relative to a benchmark.
While there is no one-size-fits-all approach to investment management, investors need to understand the differences between passive and active management and strategic and tactical allocation to pursue the best path for them.
Each approach has its advantages and disadvantages, and investors should consider their investment goals, risk tolerance, and time horizon before selecting an investment strategy.
This article will explore the pros and cons of passive vs. active management and strategic vs. tactical allocation to help investors make informed investment decisions.
Key Takeaways – Strategic vs. Tactical Allocation
- Passive vs. Active Management: Passive management involves buying and holding a diversified portfolio of securities that track an index (or group of indices), while active management involves actively trading securities and assets to beat the market.
- Tactical Allocation Challenges: Tactical allocation is more difficult to consistently execute over the long term, as it requires making frequent adjustments to the portfolio based on short-term market movements or changes in the outlook for specific asset classes. Competing with other sophisticated market participants for alpha can be challenging for individual investors.
- Diversification and Rebalancing: To minimize risk and maximize returns, it’s more important to get the passive (strategic) asset allocation right by diversifying across different asset classes, countries, and currencies. Periodic rebalancing is necessary to maintain the desired asset mix and keep the portfolio aligned with investment objectives, risk tolerance, and time horizon.
Tactical Allocation Is More Difficult
Tactical allocation involves making frequent adjustments to the portfolio based on short-term market movements or changes in the outlook for specific asset classes.
The goal is to generate alpha, or returns that outperform a benchmark, by taking advantage of market inefficiencies or mispricings.
However, the problem with being overly tactical is that it is difficult to consistently beat the market over the long term.
There are many highly knowledgeable and talented investors, as well as sophisticated machines, that are also seeking to generate alpha (a zero-sum game).
These investors have access to vast resources, including a talented research staff and the latest technology and data analytics tools, which allow them to process information faster and more accurately than the average investor.
As a result, they can identify mispricings and market inefficiencies more quickly and take advantage of them before others do.
Moreover, investing decisions made by humans can be influenced by emotions, such as fear and greed, which can lead to irrational decisions.
In contrast, machines and “expert systems” can make decisions based on predefined algorithms without any emotional biases.
Therefore, it is challenging for a human investor to compete with sophisticated machines in terms of speed and accuracy.
Understand the Risks of Tactical Asset Allocation
If you must allocate tactically, it’s generally best to do it within the context of lots of diversification because there will be lots of time where you will be painfully wrong.
Tactical allocation involves making frequent adjustments to the portfolio based on short-term market movements or changes in the outlook for specific asset classes.
While making random, sloppy decisions doesn’t guarantee losses, the majority of traders/investors who make tactical decisions in the markets tend to underperform a representative benchmark.
In the markets, there is generally a handful of traders/investors who generate alpha over the long-run, while the vast majority will underperform a benchmark.
This underperformance can be attributed to several factors, including the difficulty of consistently timing the market, bad decisions, and the impact of trading costs and taxes.
However, even if the tactical decision-making is bad, investors can still generate positive returns from being long financial assets.
This is because the overall trend of financial markets tends to be positive over the long term, and investors who hold a diversified portfolio of financial assets can benefit from the overall market trend.
This is known as “beta” returns, which refer to the returns generated by the overall market trend.
In other words, even if an investor’s tactical decisions are poor, the returns from the overall market trend can still generate positive nominal returns.
If You Are Tactical
Think about the following factors:
- What is your base case?
- What are the list of things that can make you wrong?
- How wrong can things go if you are?
- What are you missing? What are your blind spots? How do you know that you know?
- How much conviction do you have in the trade?
All of that needs to be taken into account.
The markets, like life itself, are about probabilities. There is no black-and-white sure thing.
Think about different scenarios and think about different probabilities.
Different Variables Have Different Weights
All economies work virtually the same way and have the same realities. But there are differences between them.
Different variables have different weights depending on the economy.
For example, what drives the USD is different from what drives the Malaysian ringgit. The fiscal deficit dynamics are different, the political dynamics are different, remittances have a different effect, and so on.
The economic linkages and logic are the same globally but the weights of the variables are going to be a lot different depending on where you are.
Having an Edge Requires a Deep Understanding
In order to have an edge in the financial market, traders/investors need to have a deep understanding of the market dynamics and the factors that drive asset prices.
The reality is that the financial markets are highly complex, “open systems,” and there are many factors that influence asset prices, including macroeconomic conditions (changes in discounted growth and inflation, changes in risk premiums and discount rates, geopolitical risks, among other factors).
In order to make informed tactical decisions, traders/investors need to have a deep understanding of these factors and the impact they have on asset prices.
However, this level of knowledge is difficult to achieve, and even the most seasoned and talented traders/investors can struggle to consistently outperform the market.
As a result, many investors are better off focusing on selecting an asset allocation that is suitable for their investment objectives, risk tolerance, and time horizon.
This means identifying a mix of asset classes that provides the desired level of risk and return, while also being diversified enough to minimize the impact of short-term market movements.
Ideally, the asset allocation should create balance by not being heavily biased towards a specific market, asset class, country, or currency.
This can help ensure that the portfolio is not overly exposed to the risks of a particular market, sector, place, or currency.
Instead, a well-diversified portfolio should be designed to perform well over the long term, regardless of short-term market movements.
Get Your Passive (Strategic) Asset Allocation Right
Passive management involves buying and holding a diversified portfolio of securities that roughly tracks an index.
However, it is important to ensure that the portfolio is well-diversified across different asset classes, countries, and currencies to minimize risk and maximize returns.
If you don’t know something, you probably shouldn’t have any type of bet – inadvertent or otherwise – on it.
For example, would anyone want their financial future to be dependent on:
- the future direction of interest rates
- the future direction of the stock market
- the future direction of the oil market
- and so on…
…if they had no ability to make good tactical bets on such things?
This is why many there is a lot of merit in creating a balanced portfolio with uncorrelated sources of positive returns, that has little bias of going up or down as the markets and economy get better or worse.
Asset diversification
Asset diversification involves investing in a mix of different asset classes, such as stocks, bonds, commodities, currencies, and alternative assets, to spread risk across different types of investments.
This can help reduce the impact of short-term market movements on the overall portfolio.
Country diversification
Country diversification means spreading capital over a mix of different countries and regions to spread risk across different economic and political environments.
This can help reduce the impact of country-specific risks on the overall portfolio.
Currency diversification
Currency diversification means having assets and exposures of different currencies to balance risk across different exchange rates and assets that do well when currencies are being devalued.
This can help reduce the impact of currency fluctuations on the overall portfolio.
By diversifying the portfolio across different asset classes, countries, and currencies, investors can minimize risk and maximize returns over the long term.
This is because different asset classes, countries, and currencies tend to perform differently over time, and a well-diversified portfolio can help reduce the impact of short-term market movements on the overall portfolio.
Moreover, it is important to periodically rebalance the portfolio to maintain the desired asset allocation.
This involves selling assets that have performed well and buying assets that have performed poorly to maintain the desired asset mix.
By doing so, investors can ensure that their portfolio remains well-diversified and aligned with their investment objectives, risk tolerance, and overall time horizon.
What’s Obviously Better (Or Worse) Is Not Actually Obvious
Many traders/investors believe that some companies are obviously better or worse than others, and that these differences should be reflected in the stock price.
However, the reality is that it’s not at all easy to spot a mispricing, and all available information is already discounted within financial asset prices.
This means that the market has already factored in all known information about a company, including its financial performance, growth prospects, competitive landscape, and macroeconomic environment.
Any new information that becomes available is quickly incorporated into the stock price, making it difficult to consistently identify mispricings in the market.
While markets can get out of whack due for liquidity reasons, any obvious mispricings that do exist tend to be small and short-lived.
Therefore, in order to generate alpha, or returns that outperform a benchmark, investors need to identify mispricings that the market has not yet recognized.
This requires a deep understanding of the market dynamics and the factors that drive asset prices, as well as the ability to process and interpret vast amounts of data in real-time.
The Most Important Thing = Get Involved in Markets (In a Smart Way)
While there are risks associated with investing (and practically anything in life), not taking any action can be even riskier over the long term.
The reason for this is that, historically, financial markets have tended to produce positive returns over the long term.
This means that investors who do not invest at all are missing out on potential returns that could help them achieve their financial goals.
Moreover, inflation erodes the value of money over time.
If an investor chooses to hold cash instead of investing in assets that generate a return, they risk losing purchasing power over time.
This means that the value of their savings will decrease over time, making it harder to achieve their long-term financial goals.
Therefore, it is important for investors to take action and invest their money in a suitable asset allocation that aligns with their overall investment objectives, risk tolerance, and time horizon.
This will involve taking on some level of risk, but the potential rewards over the long term can outweigh the risks.
Of course, it is important to note that investing involves risks, and investors should be prepared to weather short-term market volatility.
However, over the long term, a well-diversified portfolio that is aligned with an investor’s investment objectives and risk tolerance is likely to produce positive returns.
The Active Vs Passive Investing Debate
FAQs – Passive vs. Active Management, Strategic vs. Tactical Asset Allocation
What is the difference between strategic and tactical allocation?
Strategic allocation involves creating a long-term investment plan based on a specific asset allocation strategy that is adjusted periodically to maintain the desired asset allocation.
Tactical allocation entails making short-term adjustments to the portfolio based on changes in market conditions or the outlook for specific asset classes.
What are the advantages and disadvantages of passive and active management?
Passive management has to do with buying and holding a diversified portfolio of securities that track an index, while active management involves actively trading securities to beat the market.
Passive management tends to have lower fees and can be a good option for investors who want to minimize their risk exposure.
However, it may not be suitable for investors who are looking to generate alpha.
Active management can be more expensive, but it can potentially generate higher returns by taking advantage of market inefficiencies.
However, it’s also riskier and may result in underperformance relative to a benchmark.
Is it better to adopt a strategic or tactical allocation approach?
There is no one “correct” approach to investment management, and the choice between strategic and tactical allocation will depend on an investor’s individual circumstances.
Strategic allocation is generally more suitable for long-term investors who are focused on achieving their investment goals over the long term.
Tactical allocation may be better for short-term investors who are looking to generate alpha by taking advantage of what the market might be missing.
Is it possible to beat the market through tactical allocation?
While tactical allocation can offer short-term benefits, it is challenging to consistently beat the market over the long term.
This is because it’s a competition among many other talented people/machines/market participants who are also seeking to generate alpha.
Moreover, investing decisions made by humans can be influenced by emotions, which can lead to bad decisions.
Therefore, it is generally not prudent to adopt a highly tactical approach to investment management.
Is it better to invest passively or actively?
It’s up to each person.
Passive management tends to be a good option for investors who want to minimize their risk exposure and avoid high fees.
Active management may be better for those looking to generate excess returns and realistically believe they have an edge to do this properly.
What is the most important thing to consider when investing?
The most important thing to consider when investing is to have a clear investment plan based on a sound asset allocation strategy that is aligned with your investment objectives/risk tolerance/time horizon.
This means identifying a mix of asset classes that provides the desired level of risk and return, while also being diversified enough to minimize the impact of short-term market movements.
By doing so, investors can potentially achieve their long-term financial goals and mitigate the risks associated with not investing at all.
Conclusion
When it comes to investment management, there is no one best approach.
The choice between strategic and tactical allocation, as well as passive and active management, will depend on an investor’s investment objectives, risk tolerance, and time horizon.
Investors who are looking to achieve their long-term financial goals should focus on developing a sound investment plan based on a diversified asset allocation strategy that minimizes the impact of short-term market movements.
They should be prepared to withstand short-term market volatility and avoid making rash investment decisions based on fear/greed/other emotions.
Moreover, it is important to recognize that investing involves risks, and investors should be prepared to take on some level of risk to achieve their goals.
However, the potential rewards over the long term can outweigh the risks if investors are disciplined and patient.
Lastly, don’t be afraid to seek professional advice.
Financial advisors can provide guidance and help investors make informed investment decisions that are aligned with their circumstances.
They can also help investors avoid common investment pitfalls and make sound investment decisions that can potentially help them achieve their long-term financial goals.