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Carl Richards takes a poke at tactical asset allocation (TAA) in a recent column in The New York Times. The financial planner reprises a familiar criticism of TAA, advising investors to "forget market timing, and stick to a balanced fund." TAA, he asserts, is just market timing with a fresh coat of marketing paint. The reasoning behind his critique: it's hard to beat the market (or a passive asset allocation mix) over time. Agreed. We should be wary of hubris when it comes to expectations of what we can achieve by outsmarting everyone else. But what Richards doesn't discuss is the all-important gray area between the extremes of aggressive market timing and a quasi buy-and-hold strategy that purports to relieve you of the task of rebalancing, which some may call market timing.

Attacking TAA and other short-term trading strategies is easy and to some extent satisfying. But there's a danger in going too far towards the other extreme in the belief that you'll find financial nirvana by doing close to nothing. Here too the numbers tell a compelling story. Holding, say, an equally weighted, unmanaged mix of stocks and bonds did quite well in the years ahead of 2008. But the genius of the bull market collapsed in the 2008 crash. Rebalancing (or market timing, by some definitions) could have helped.

Granted, it's hard if not impossible to recognize in real time when a given market has peaked or hit bottom. In fact, it's best to assume that we'll always be wrong in such affairs. But that's hardly an argument to forgo rebalancing. Yes, the details matter… a lot. You can't spend too much time thinking about how and when you'll rebalance the portfolio.

Is rebalancing really just market timing by another name? It can be, depending on what you're doing and how you define your terms. But don't get caught up in semantics. In fact, it's best to forget this silly debate about whether market timing/tactical asset allocation/rebalancing is productive on a grand scale. There are only gray areas in money management. The main question that every investor (and institution) should focus on: What gray area is right for me (us)?

The cold, hard reality is that there are two primary factors that will determine investment outcomes. First, what assets/asset classes will populate your portfolio, or not? Second, how will you rebalance the mix, or not?

Let's clear up one issue right away. If you choose not to rebalance, or relegate the decision to some distant point in the future that will addressed infrequently, if at all, you're making a bet. A big bet, and one that has good chance of delivering dismal results eventually, in part because of behavioral factors. Again, history is quite clear on this point. Think of the buy-and-hold investor with an unmanaged balanced fund going into 2008. For years, he enjoyed healthy, even stellar returns. But after it all came crashing down in late-2008, he was shocked to see his quarterly statement and cashed out and a decade or more of buy-and-hold success was destroyed.

Selling at the bottom is the bane of the average investor. Rebalancing could have helped, if only because it keeps you involved along the bumpy road to success by staying engaged with the all-important business of risk management. But what about uncertainty and our inability to forecast the future? Doesn't that imply that we should forget rebalancing? No, and here's why.

Let's say that you've made a reasonable decision to hold a diversified mix of asset classes as a basic risk-management tool. Good choice, although it's incomplete if we leave it there. Effective risk management requires that we periodically rebalance this mix. How can we do so with some degree of efficiency? There are many ways to proceed, but a prudent start is monitoring the returns in search of those periods when performance is relatively extreme. Predicting returns is a fool's errand, but analyzing trailing performance is easy and can reveal a lot.

One quick example: Earlier this month I noted that US equities had generated unusually high returns vs. the other asset classes in recent history. Actually, I made a similar observation last October and so in one sense I was wrong. The hefty returns for US stocks in October persisted through January. In recent trading sessions, of course, US stocks have fallen sharply. I have no idea if this is the start of a bear market or a pause before the market touches new highs later this year, and no one else does either.

What I do know is that taking some profits in asset classes that have enjoyed extraordinarily strong returns in recent history is a sound risk-management strategy. Buying asset classes after they've been pummeled is equally important. How do you know if returns are in the outer reaches of the historical record? Well, you spend some time analyzing the asset class. By definition, extreme returns are rare, but that's okay because we want to minimize trading costs, taxable events, and other frictions by trading as little as possible while keeping risk under control.

Should you go all in, or all out, when you make these decisions? No, probably not. That's too risky, given the uncertainty about the future. But shunning a well-designed rebalancing strategy because of a misguided notion that it's "market timing" is also going off the deep end.

The bottom line: debates about what constitutes market timing vs. rebalancing vs. buy-and-hold investing are a waste of your time. Instead, focus on the hard work of plotting out a strategy for how and when you'll adjust the asset mix. If instead you've decided to let your initial asset allocation do all the heavy lifting, well, good luck with that. Almost no one succeeds with a hands-off strategy because of those pesky behavioral issues. As such, most of us should be in a gray area of portfolio design and management. The real challenge is figuring out what gray area is appropriate for you.

Source: Looking For Investment Success In Gray Areas