Tactical asset allocation may be the perfect middle ground between market timing and buying and holding.
There are two types of people in this world: those who divide the world into two types of people and those who don’t.
That old joke sums up the argument between those who promote a strict “buy-and-hold” strategy and others who completely reject it in favor of “market timing.”
This polarized view of the two strategies seems extreme—like the Manicheans who divided the entire world into either good or evil. There should be room for an intellectual middle ground that respects the philosophy supporting both approaches. My centrist opinion will surely draw criticism from both sides, but the fact remains that each strategy has serious flaws.
A particularly severe bear market popularizes the belief that “buy-and-hold is dead”—and for good reason. Riding a bear market into the ground is an excruciatingly painful experience. Active managers point out (justifiably) that under those circumstances, an effective sell strategy could avoid severe losses (not to mention the emotional pain) as well as provide cash reserves that could be reinvested at lower price levels.
On the other hand, passive managers and indexers will point out that this argument is based on the dubious assumption that active managers can effectively time the market. They argue that the preponderance of evidence refutes claims that market timers can consistently sell near the top or buy near the bottom.
Twenty-five years of personal experience trying to time the market convinced me that I couldn’t do it consistently enough to claim success. The mixed results of investment “geniuses” and gurus extended that belief to include everyone else. So I chose a more passive approach in order to shift my focus to reducing risk and expenses in lieu of increasing potential returns.
This created a dilemma. A strict buy-and-hold discipline ignored the value strategy I learned by studying Benjamin Graham and his disciples. After all, the most fundamental rule of investing is “buy low, sell high,” so a strategy that doesn’t consider market valuation seemed fatally flawed.
Yet any deviation from “buy-and-hold” would inevitably put me on the slippery slope of market timing. Setting aside the problem of how best to value the market (given that value is in the eye of the beholder), it seems foolhardy to ignore the valuation issue even if you question market timing as a strategy.
A reasonable alternative is to employ a tactical asset-allocation policy. This can modify the strategic long-term asset allocation during periods of perceived over or undervaluation. As opposed to an “all-in” or “all-out” market-timing approach, a tactical asset overlay allows you to adjust your allocation in response to significant changes in market conditions. While this more nuanced alternative eliminates none of the fundamental problems inherent in either strategy, it does recognize the advantages of both approaches.
This tactical shift acknowledges the lopsided risk/reward relationship present at market highs and lows. While an “overvalued” market does not guarantee future price declines (since the fundamentals could catch up to prices), it does represent diminished reward potential and increased risk. If you are not being adequately compensated for taking risk, then placing at least some investment capital in reserve makes sense.
Cash reserves can also provide a psychological benefit. It’s unnerving to be fully invested in a rapidly declining market when the only course of action is to sell. Holding cash reserves can steady an investor’s nerves under those conditions. Whether that cash is actually reinvested at lower prices may not be as important as the psychological strength it gives the investor—a feeling of having at least some measure of control in a difficult situation.
I don’t believe that following a tactical allocation strategy makes me a closet market-timer or invalidates my faith in a generally passive buy-and-hold strategy. While this strategy may not be orthodox, it’s more pragmatic than an uncompromising commitment to either doctrine.
Those who dogmatically pursue a strategy in spite of contradictory evidence seem driven more by blind faith than intellect. You could say (as Michael Falk did more succinctly) “the dogma ate their homework.”