The idea of tactical asset allocation when it comes to your mutual fund investments can mean a couple of things. Either way, it will involve some risk taking on your part as the investor. However, in saying as much, remember that the nature of mutual fund investments is to diversify out the risks by holding several properly-qualified securities in the first place, so the risks are not so much in the security selection as they are in the strategy itself. Let’s take a closer look at the two types of mutual fund investments…

Tactical Asset Allocation Means Making A Call On Asset Classes

In the most basic sense of the word, tactical asset allocation involves taking an overweight-underweight approach to specific asset classes. For example, if you have noticed that equity markets are starting to come off their lows and have surpassed a safe margin (say 20% above their lowest 52-week trading range) you might decide to adjust your equity position accordingly. A tactical asset allocation program might go overweight on equities if the program calls for such action (which would be determined far-ahead of time, not arbitrarily).

For many people, the above example would be a natural call to increase equity weightings. However, contrarian strategies would advocate taking an underweight position in equities and an overweight position in fixed income. Whatever decision you make if you choose to undertake a tactical asset allocation program should be determined well ahead of time, and not at the time that the market records such milestone increases (or decreases) from its highs/lows.

The risks here are that you choose the wrong funds as well as the wrong asset class weighting.

Tactical Asset Allocation Can Also Mean Active Security Management

Tactical asset allocation need not be solely undertaken by the individual investor. In fact, most balanced funds use tactical asset allocation to manage their returns, beat the index and keep investors happy. This is nothing new for most balanced funds, as many of them will invest more heavily in income investments when yields suggest opportunities exist to easily out-perform the index and will invest more heavily in equities when prices are considered undervalued. (There are many different ways of describing this type teeter-totter relationship between income and equities; bond-strong fund managers may manage solely based on yield curve or other bond-specific measurements whereas equity-strong managers may manage based on P/E ratios, dividend payouts, as well as a long list of other equity-specific measurements).

The risks involved with balanced mutual funds that make tactical asset allocation a part of how the fund operates lies with the fund manager. All it takes is one bad decision and reversing those misfortunes can be a devastatingly slow and painful process. Consider for example a balanced mutual fund that manages $5 billion worth of money where the fund manager decided to move 80% of the assets into bonds. If the timing was wrong or if the call itself was wrong and the manager needs to reverse this decision, he or she will need to trade upwards of $4 billion in assets, a truly substantial figure that would not go unnoticed by other traders.

The point is simply that a balanced fund manager’s goal is to outperform an index, whether it is the S&P 500 or some other index or a combination of several, the goal is just that: to outperform. In fact, their pay is often determined by how well they outperform the index or other standard, which is why tactical asset allocation involves accepting only the necessary risk to achieve above-standard returns.

Tactical asset allocation involves accepting only the necessary risk to achieve above-standard returns

With the above in mind, remember that returns are always risk-adjusted. It makes little sense to arbitrarily manage your personal portfolio using tactical asset allocation if it “might” mean a healthy return in one period, but five consecutive poor returns that follow. Incorporating tactical asset allocation programs up front is another matter; it becomes part of your asset allocation model, or your investment plan. This means that, right from the start, you will be investing in mutual funds (or other vehicles) that allow you to achieve your investment objective.