Tactical Asset Allocation
Tactical Asset Allocation strategies aim to outperform traditional buy and hold portfolios by dynamically adjusting positions and weights within the portfolio based on a variety of factors. Those factors are often weighted based on perceived relevance to the strategy or objective.
The Elastic Asset Allocation strategy incorporates the following factors:
The momentum component looks for consistent strength in a stock's price movement. The premise behind momentum analysis is that stocks that have shown consistent strength in the past tend to continue showing strength going forward.
For a complete explanation, you can refer to this article on correlation. To summarize, correlation is the tendancy for two stocks to move in the same direction at the same time.
The correlation used in the EAA is based on calculating an index of all positions within the portfolio and then calculating the correlation of each individual position relative to that index.
Volatility is the standard deviation of returns and is often used to define the risk of a stock or portfolio. A lower volatility is typically thought to indicate lower risk. This is a very generic and broad way to think about volatility but it can be useful, especially when combined with additional factors.
The EAA algorithm combines the above factors by computing a geometrically weighted score. The geometric weights are known as elasticities because they reflect the relative change in the position size for each asset, when the above factors change.
The EAA combines the above factors into a scoring function known as 'generalized momentum' to determine each asset's allocation within the portfolio.
The weights of each factor can be changed depending on your objective. Two such settings recommended by the authors of the EAA are known as the 'Golden EAA Models' which include an offensive and defensive setting.
The EAA also incorporates a crash protection component. This is based on absolute momentum and replaces a portion of the portfolio with cash (or a cash alternative) depending on the fraction of assets with non-positive returns.
The EAA is intended to be used for rebalancing at regular intervals eg: Monthly. For example, you might define a universe of 15 stocks and ETF's to run the EAA against. Based on the results you would rebalance and remove positions accordingly.
The following month, you would again run the original 15 stocks through the EAA algorithm to determine the new allocation.
This article provided a brief overview of the Elastic Asset Allocation strategy. For more information you can read the complete white paper here.
The asset allocation tool provided by Diversify Portfolio provides you with an implementation of the EAA to use with your stock portfolio. More information on the tool can be found here.
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