Use Tactical Asset Allocation to Improve Your Returns

When it comes to setting up an all-purpose investment portfolio, dividing your money among different types of assets is the simple yet effective way to get started. Yet to take your investing to the next level, consider whether a technique known as tactical asset allocation will give you the added flexibility you need in order to boost your returns even further.

Last week, we took a look at the basics of strategic asset allocation to give you a taste of how the strategy works. Although it sounds similar, tactical asset allocation actually works a bit differently. Let's take a look at the differences between the two methods with an eye toward seeing which is better suited for you.

How it works
In general, tactical asset allocation starts out with the same basic decisions as other asset-allocation strategies. By choosing which types of assets you want to invest in and then figuring out how much of your money you want in each, you can capture the vast majority of the returns available from those investments. Even if you decide to stick with broad-based exchange-traded funds rather than drilling down to the individual stock level or figuring out which other specific securities you should include in your portfolio, you'll still get most of the returns available from asset allocation generally.

Where tactical asset allocation differs, though, is in its execution. Rather than defining strict percentages to allocate to particular asset classes, you instead give yourself broader ranges of allocations. Then, depending on market conditions, you choose where within each range you want to invest currently, with the intent of revisiting those allocations in the future once conditions have changed.

Exactly how you determine those positions, however, differs from person to person. Value investors may prefer to push allocations down when a particular asset class gets expensive. Momentum-driven investors, on the other hand, will typically do the opposite, hoping to ride an intermediate-term or long-term trend as far as it will go. There's no right or wrong answer, but you should make sure the particular implementation you pick fits well with your overall investing temperament.

The benefits of tactical asset allocation
In practice, tactical asset allocation creates investing flexibility in two different ways. Both are based on relative valuations, but they differ in the investments you'll typically choose.

For those with established portfolios but who don't have much money to add, such as retirees, tactical asset allocation often involves moving money among existing positions or deciding which assets to sell to raise cash. For instance, right now, with stocks having advanced substantially over the past few years, value-oriented investors in retirement would feel comfortable paring stock positions to provide cash for living expenses.

If you're a younger investor and are still adding money to your portfolio, though, you'll use tactical asset allocation to decide where to invest new money. For instance, the same value investor might target coal stocks Alpha Natural Resources (NYS: ANR) , Peabody Energy (NYS: BTU) , and Arch Coal (NYS: ACI) , each of which has had terrible stock performance over the past year but has started to come back recently as prices for competing natural gas have bottomed. If you're inclined to boost your stock exposure, you might choose those stocks as turnaround candidates. On the other hand, momentum-driven investors looking to boost stock positions might instead choose Michael Kors (NYS: KORS) and MasterCard (NYS: MA) , both of which have continued to push higher on strong growth despite rich valuations.

Invest like a pro
Many people equate tactical asset allocation with market timing, as it makes portfolio changes based on short-term conditions. However, because the ranges of asset allocations are typically fairly narrow and predefined, there's still enough discipline to give you the support you need to follow a long-term strategy based on the method.

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Fool contributor Dan Caplinger has no positions in the stocks mentioned above. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of MasterCard. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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