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Post-financial crisis commentary on tactical versus strategic asset allocation

The best individual financial planning and investment rules and practices are enduring and should not change due to market cycles or a financial crisis. This article looks at asset allocation strategy in light of the recent credit crisis.

The credit crisis was a systemic, global financial event that impacted any financial or securities instrument influenced by debt and borrower credit worthiness. In short, the credit crisis affected everything. So many investors sought liquidity at the same time, because they either had to do so to meet their cash flow obligations and/or they feared greater losses and sought “safer” places for their money. Presto — the result was a global valuation downdraft that affected all asset classes. While some — but not all — classes of bonds did better relative to other asset classes, the real beneficiaries were those who already held bond positions before broader groups of investors got into a panic.

Whenever you are already there and invested in an asset class, it means that you probably were already following a passive asset allocation strategy. While tactical asset allocation strategy advocates will suggest that you can anticipate the crowd, this is not verified by studies of flows-of-funds into and out of investment mutual funds. While a very narrow segment of investors might have some skill in anticipating trends and does actively pre-position their investments relative to the movement of the crowds, most people already have their money invested in an asset class, because they have chosen strategically to be invested in that asset class for the long-term as a buy-and-hold investor. Flow-of-funds studies show that almost all tactical asset allocation fund flows are late money flows that chase performance after valuations have already moved. On average, this tactical asset allocation money is late money and these investors get inferior returns.

At the end of the first decade of the new millennium, huge cash flows into bond funds still continued relative to flows into other asset classes, such as stocks. This is a trend that was almost three years in the making. We have not seen similar disproportionate fund flows into bonds since the 1984 to 1987 period, when interest rates were much higher than today’s paltry yields. In succession during the past decade, we have experienced a technology bubble market crash, a housing bubble crash, a credit crunch, and a resulting global economic/business cycle crash. Barring a total global economic depression, which we seem to have skirted but avoided, what will happen to the bond markets when interest rates inevitably rise? Stay tuned for the next sector bubble crash.

Recently, there has been more advocacy of “tactical” asset allocation strategies by certain financial advisors. The logic goes as follows. Broad passively-managed asset class diversification strategies seemingly did not work during the credit crisis. Even broadly diversified investor portfolios went down, although not as much as portfolios that were more exposed to particular asset classes that had suffered the worst percentage declines. Therefore, buy-and-hold strategic asset allocation apparently did not work and should be thrown out. As a replacement, these financial advisors advocate that it is time to employ tactical asset allocation strategies that ‘could’ get better risk-adjusted portfolio returns in the future. You know, start moving things around to get ahead of the crowd and be there before the crowd arrives to drive up valuations.

Unfortunately, tactical asset allocation strategy advocates do not offer anything to back up their claims that tactical investment activity would actually be superior to a passive asset allocation strategy in the future. Tactical asset allocation strategies have not been superior in the past. Advocacy for tactical asset allocation strategies flies in the face of the broad body of investment research that consistently has shown that low-cost, broadly diversified, passive buy-and-hold asset allocation strategies tend to yield superior long-term risk-adjusted portfolio returns.

Broad portfolio diversification has never meant that a portfolio could not and would not experience short-term losses at the portfolio level. When you have an investment banking industry that finds clever ways to repackage smelly sub-prime mortgages as gilt-edged investment grade derivative mortgage securities and resells these stinkers in vast quantities to other “smart money” financial professionals across the banking and investment world, then we just might all have a problem. When doing this over and over gets a lot of clever investment banking types some very large bonuses, then there is a lot of motivation to keep that gravy train moving along.

While you might question the ethics of these clever investment bankers, you should not forget that they sold these toxic mortgage securities to other willing professional buyers in the global banking industry. Those professional banker purchasers, in turn, tucked these gilt-edged derivative securities into their banks’ capital asset portfolios — the very capital portfolios upon which the banks ran their leveraged loan operations. When the music stopped and all the emperors had no clothes, bank capital evaporated and so did their ability and willingness to make loans. Of course, this was all compounded by tens of trillions of dollars in CDOs (credit default swaps) that tried to pass the ultimate repayment responsibility for bad debt hot potatoes around. Did the investment bankers also make some sweet bonuses on the multi-trillion dollar CDO market? You betcha!

Without your taxpayer dollars via the TARP bank bailout, the US and the rest of the world would all be in the financial black hole of a long-term global financial depression. In that event, most people would not have had to worry about short-term paper losses on their investment portfolios. Instead, many would have liquidated their portfolio holdings at cents on the dollar to meet living expenses after their jobs vanished.

If you have been following the chatter, you might remember hearing that most TARP funds have been paid back and some TARP loans to the banking industry have been reasonably profitable. Of course, this supposed profitability is only positive from a very narrow perspective. Taypayers are not normally in the business of making bailout loans to the financial industry. While unfortunately necessary, it is difficult to argue that TARP loans were profitable to taxpayers, when you consider the vast global economic destruction that resulted; the job losses and the millions unemployed and under-employed; and the unreimbursed hole that many still have in their personal investment portfolios.

So, when a huge and systemic toxic asset problem exists in the financial system, and the credit house of cards begins to fall, why would or should a diversified strategic asset allocation strategy prevent a short-term loss at the portfolio level? And, why would tactical asset allocation be a superior replacement strategy? To the contrary, higher cost, less diversified, active investment strategies will do what they always do, which is lead on average to inferior risk-adusted returns at the porfolio level. Even in a dire financial crisis, you should not lose sight of the long-term and forget the lessons of financial history. Broadly diversified, passive, low-cost, buy-and-hold strategies have been superior in the past, and they are much more likely to beat tactical asset allocation strategies in the future.

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Roth IRA calculator tools are needed to make a thorough lifetime financial plan

This free financial freedom website publishes documents regarding how to make a personally customized personal financial planning program strategy

The personal financial planning program strategy postings on this free website give individuals and families important ideas about family financial planning issues that they should think about. Our publications help in establishing a life time personal finance planning strategy. In addition, to make a fully personalized lifetime financial plan requires that you use a leading financial planning tool with a superior investment calculator and the top financial planning worksheets.

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Roth IRA and Roth 401k Accounts and Roth Estate Planning Strategies

There are trade-offs in deciding how to set the proportion to contribute into Roth retirement savings accounts versus making contributions to traditional retirement accounts with tax deferral advantages. Please use the links at the bottom of this article to read our previous articles on the subject of an optimal Roth retirement account contribution strategy.

In many senses for some people, an optimal Roth retirement account contribution strategy also becomes an estate planning question. In the majority of personal finance situations, making 100% of allowable Roth contributions may not yield the greatest total estate at age 80, 90, or 100, when compared to the opportunity to make currently tax deductible contributions traditional personal IRA and traditional 401k, 403b, KEOGH, and other retirement plan accounts that reduce current taxable income.

However, when you expand your total present value analysis to include the long-term value to a multi-generational family, then Roth assets can have significantly greater value. If Roth assets remain at death, there are very significant long-term multi-generational tax avoidance advantages. In such circumstances where it is likely that a person’s assets will be adequate to cover retirement expenses even with a very long life, then it can be advantageous to live off of traditional retirement plan assets, which are subject to mandatory withdrawals and associated income taxation in retirement anyway. This means that over ones lifespan, when retirement assets are adequate for the long-term, then a larger and increasing proportion of ones future financial asset portfolio could consist of Roth assets.

For estate planning purposes, Roth retirement accounts can have some very significant advantages over traditional tax-advantaged retirement accounts.

If a family’s financial model indicates that there is a strong possibility that they will still have some tax-advantaged account assets at death, then those should be Roth tax-advantaged account assets, when feasible. Roth assets can be inherited by children and other designated beneficiaries, and these inherited Roth assets can also grow tax-free over the expected life of the person inheriting with certain mandatory withdrawal requirements.

For example, this means that a child inheriting from a very elderly senior citizen parent Roth retirement account assets, when that child is age 50, could perhaps enjoy another 40 years of tax-free investment growth with an income stream along the way. Under current law the child would face from mandatory, but non-taxable withdrawals. Only when withdrawn asset have appreciated in taxable accounts, would the fruit of these inherited Roth assets be subject to short-term or long-term capital gains taxes. Traditional tax-advantaged retirement accounts do not provide these very significant and valuable estate planning benefits.

You should note that the rules regarding Roth retirement plan accounts are in flux.

It is not clear what they might be over the course of your life. However, income limitations have changed and traditional to Roth asset conversions seem to be possible without income restrictions during 2010. These year-to-year changes are the reason why it makes a lot of sense to download from the IRS website and read the relevant US income tax publications, including IRS Publication 560 and IRS Publication 590. Again, consulting a knowledgeable certified public accountant may help you with current rules strategy.

Furthermore, you should also use the top retirement investment planning calculator to better understand the potential size of your projected Roth retirement nest egg assets in the future. You should find out whether you could be one of the minority of the US taxpaying population that could mass significant Roth retirement account assets and be able to pass them to your heirs with the associated tax advantages to your beneficiaries.

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Retirement planning calculator software is highly recommended, when you want to develop a superior family financial strategy

This free “steps to financial freedom” site publishes articles regarding how to establish a do-it-yourself personal finance plan

The personal finance plan essays on this free website supply important thoughts about financial planning strategy topics that you may wish to consider. Our publications can help you in your efforts to establish a high quality, full life personal financial planning strategy. In addition, to produce a fully comprehensive long-term money management strategy depends upon you using superior financial planning software with the top investment planning software and the leading financial planning tools.

This free financial freedom online website also enables you to find the best ALL-IN-ONE financial calculators tool set, which includes the top retirement planning calculators program, high quality life time personal budget software, and the best investing calculator for your self-directed lifetime financial planning.

Tax-Advantaged Retirement Savings Plans

You may have the opportunity to make investments into both individual retirement (IRA) accounts and into employer or self-employed tax-advantaged retirement plans, such as a 401k. In general, if your retirement saving planning allows sufficient annual retirement savings from your earnings, most retirement investment advisers would recommend that you make the full contributions each year into these various plans through out your employment up to when your retire.

Even when you find that you cannot deduct from your income taxes your annual contributions to retirement plans, very often it still makes long-term retirement financial planning sense to make those IRA and 401k contributions, since future appreciation of these assets would be sheltered from ongoing taxation.

Traditional Tax-Advantaged IRA Contributions Versus Roth Retirement Account Investments

The article that follows provides information that will allow you to understand better the trade-offs between “traditional” and “Roth” tax-advantaged retirement accounts. Understanding the trade-offs between traditional IRA and 401k retirement contributions versus Roth 401k retirement plan contributions and Roth IRA contributions requires automated analysis of all the factors that impact this decision. Back-of-the-envelope calculations can easily be simplistic, incorrect, and deceptive. This decision can only properly be made with the assistance of a comprehensive retirement planning tool. If you do not have access to retirement planning software that can do this analysis for you, you really should get such a retirement planning software tool. The dollar amounts involved can be very large over a lifetime. Following uninformed instincts can lead to a highly sub-optimal retirement savings plan and you could accumulated many thousands of dollars less than you might save with a more optimal tax-advantaged retirement investing strategy.

For the majority of Americans, such retirement planning tools develop projections indicating that it would be more advantageous to make contributions to traditional tax-advantaged retirement accounts rather that Roth tax-advantaged retirement accounts. This tends to be true, whenever those saving for retirement can take advantage of the current tax deductibility features of traditional tax-advantaged 401k and IRA account investments.

However, when retirement savers cannot take advantage of current deductibility to reduce current taxable income and their income still allows some level of retirement plan contributions, then Roth contributions are preferred, if the tax rules allow such Roth retirement plan contributions. While the majority of retirement savers would prefer traditional retirement plan contributions to reduce current taxable income, whenever possible, you should monitor the situation each year to understand the rules in effect in a particular tax year. Unfortunately, the tax-advantaged retirement plan account rules are quite complex and some rules have been shifting from year to year.

The best way to understand this topic yourself is to download from the IRS website Publications 560 and 590. Grab some coffee and dedicate a few hours to the task of learning about retirement plan taxation. This could be a very valuable expenditure of your time, particularly if you want to answer the question: “how much do I need to retire?” and you recognize that whether your retirement savings account assets are “pre-tax” or “after-tax” can make a huge difference in determining how much money do I need to retire?!. Of course, a knowledgeable certified public accountant could also be helpful, if you would rather pay someone else to help you learn the rules.

The retirement account article that follows provides information that will allow you to understand better the trade-offs between “traditional” and “Roth” tax-advantaged retirement accounts. A subsequent article discusses the estate planning and the inheritance advantages of Roth retirement savings accounts, which can be very substantial, if your assets are likely out-live you.