I begin with some thoughts on market timing and tactical asset allocation. First, note that tactical asset allocation should not be confused with strategic asset allocation, which has a long-term focus. On the other hand, tactical asset allocation and market timing have some similarities that can easily result in confusion.
Market timers and tactical asset allocators sometimes make quite similar moves. For example, at similar times, both might increase stock allocations and decrease bond allocations or vice versa. It appears, however, that the thinking processes behind those moves and the skills required are quite different.
A market timer may use a variety of tools but requires self-confidence in dealing with an unpredictable stock market. Moves made might be based on the valuation of the market but are certainly not restricted to that. The consensus seems to be that market timing is difficult; certainly, for most of us it is not a promising approach.
A tactical asset allocator attempts to overweight undervalued asset classes and underweight overvalued asset classes. He believes that in the long term the probability is high that valuation levels will return to normal. He requires the ability to judge relative valuation levels and the patience to await those changes in valuation level. Tactical asset allocation seems a more viable proposition than market timing, but to the extent that it resembles market timing, it is sometimes scorned for similar reasons. Re-balancing a portfolio includes an element similar to tactical asset allocation since it tends to require selling the recently good performing and hence overvalued asset class and buying the recently poorly performing and hence undervalued asset class.
The differences between market timing and tactical asset allocation include attitude, skills and focus required, and personal qualities. Market timing requires confidence to make moves in advance of a hard-to-predict stock market, while tactical asset allocation requires the humility that you can't predict the market but that in the long run the market is Buffett's "weighing machine". Market timing requires the skill and focus on the study of the stock market while tactical asset allocation requires the study of relative valuation levels. Market timing requires the personal quality of self-assurance while tactical asset allocation requires patience.
I think that most investors should choose an appropriate strategic asset allocation first. Then an investor might be able to add value with a limited amount of tactical asset allocation to adjust the strategic allocation. In any case the personal qualities most needed seem to be patience and perseverance.
I would recommend that, for most investors, tactical allocation be limited to 5-10% of the portfolio. It has been suggested that if you just can't resist doing "something" with your investments, allocate 10% to play with and leave the rest alone. I suspect that tactical allocation is my "play with" money. After all, I spend so much time studying the stock market, I have to do "something", don't I?
Over longer periods of time, growth and value seem to perform similarly. But over shorter periods of time, either growth or value seem to have significant periods of under or out performance. Thus, a tactical allocation can periodically be made to overweight growth or value, small or large cap.
I began my efforts at tactical allocation rather inadvertently. For my retirement account, I chose a rather conservative 50-50 split between a stock and fixed account. Rather than rebalance, I let the stocks run during most of the long 1982 - 1999 bull market. See lesson 1, 50-50 split: Where it leads and what it means . Only late in the bull market, as the stock over-valuation became increasingly obvious did I begin to rebalance aggressively to a lower stock percentage. But, of course, this is no longer mechanical re-balancing; it is tactical asset allocation.
In the last several years there have been opportunities in two under-valued asset classes, REITs and Junk Bonds. At present, there appear to be no obviously undervalued classes (what the No-Load Fund Analyst calls "fat pitches"). That does mean a tactical asset allocator is tempted to move a bit further afield. Two possible opportunities are in global bonds and commodity futures. These are not traditional tactical allocation choices since they do not appear to be under-valued asset classes. Global bonds are chosen to hedge a worrisome risk in the U.S. current account deficit. Commodity futures are chosen to hedge inflation risk and to diversify the portfolio when future performance of other asset classes appears to be lack-luster.
I am convinced that a limited amount of tactical allocation can add value, but I believe the main value comes from choosing a strategic asset allocation and sticking patiently with it over a long period of time.
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