2. Implement a Tactical Asset Allocation

Studies show that close to 90% of investment returns are determined by portfolio asset allocation. Yet most value oriented guidance focuses on choosing individual investments.

Don’t get me wrong. I spend a great deal of time looking for individual undervalued investment opportunities. Finding individual investments with a margin of safety is an important aspect of value investing. However, choosing your asset allocation is more important and therefore deserves your serious attention.

Simply stated, investment allocation is how you divide your assets between different investment classes or groups. A tactical asset allocation provides the investor a dynamic strategy that adjusts to favorable and unfavorable valuations. Instead of a strict fixed percentage you have greater flexibility because you can choose from a range based on valuation levels.

Different valuation levels should require a different investment allocation of your capital. One of the most important concepts in investing is to be careful or prudent about the price you pay. It’s not possible to do this without changing your allocation to asset categories after they make large price swings.

The value oriented investor would want to allocate more to assets that were priced the farthest below their real or intrinsic value. Assets that are priced above their real worth can be completely avoided or minimized.

We know from history that when valuations are high the expected long term (7 – 10 years) rate of return is lower than average. But when valuations are low the expected long term rate of return is much higher than average.

Consider your investment allocation during the first decade of this century. Should your portfolio have held the same percentage of equities when valuations were sky high (i.e. 2000) compared to after they fell 57% in 2008-09? Of course not.

We live in the best era in history for investing. Competition has reduced transaction costs on individual investments and produced new investment vehicles (i.e ETFs). This allows investors to move from overvalued assets to undervalued assets with relative ease. It no longer makes sense to maintain positions in grossly overvalued assets.

A tactical asset allocation is an effective means to portfolio risk management. During time periods when investment assets are overvalued an adaptive allocation allows an investor to increase cash positions. Cash can help protect your portfolio in bear markets. You cannot buy low and sell high by allocating money to assets that are expensive.

At the same time, having cash available when market valuations are low provides investors the ability to take advantage of favorable opportunities. Think about how much better you would do if you bought more when prices are low and less when prices were unfavorable. Many investors do just the opposite and wonder why long term returns suffer.

You should expect volatility and take advantage of it. Make it a point to understand how volatility affects performance. Here is a post that will help you understand why you MUST control your portfolio losses and reduce your portfolio volatility.