The basis of my investment strategy is the fact that asset allocation choices are the biggest driver of returns. Investors often grapple with the push and pull between two main strategies - strategic and tactical asset allocation. You don’t need to scroll too far through investing forums or Facebook groups to find prophets for both strategies even if they are not aware of the technical terms for what they are advocating for.

Strategic asset allocation is your long-term asset allocation target. This is aligning your asset allocation with the return you are trying to achieve for your portfolio. For example, if I have gone through the portfolio construction process and calculated that I need 7.5% p.a. to reach my retirement goal in 34 years, I would allocate my portfolio between aggressive/defensive assets based on that. This process may lead an investor to decide on an allocation of 90% growth assets and 10% cash to achieve a goal.

A tactical asset allocation is a short-term deviation from this strategic asset allocation that is made based on market conditions. For example, increasing exposure to core bonds because of a belief that they are attractive under current market conditions.

Making a tactical asset allocation decision should not be done lightly because regardless of the rationale, this is market timing. However, investors can take advantage of undervalued or attractive opportunities given specific circumstances – if they have liquidity, if they are not deviating too far from their strategic asset allocation and if they have the time horizon required for the investments that they are investing in.

In many cases a tactical allocation decision involves cash. An average investor is probably not going to move 2% of their portfolio from listed property to infrastructure because they see some anomaly in the relative positioning of those two asset classes. It is more likely somebody might invest extra cash in shares or broad-based ETFs if they see an opportunity or build up a bit of cash if they don’t see opportunities.

This is an underrated aspect of cash. Having some cash in your portfolio allows you to take advantage of opportunities. Having some cash in your portfolio means that you can buy shares when they are on sale.

Some investors try to mix strategic and tactical allocation with an approach called ‘Core/Satellite’.

A hybrid approach

Core/Satellite is an investment approach that is supposed to combine the benefits of a passive and active strategy. It’s commonly used by financial advisers for their clients’ investment portfolios. It has also caught on with individual investors as my guilty pleasure of lurking through investing groups yields many mentions of this strategy. Usually, it is investors spruiking their individual holdings for their core and satellite portions of their portfolios. The passive portion brings the benefits of passive in the core portfolio while the satellite is used to speculate and try and beat the market. The satellite portion of the portfolio can be thought of as a tactical allocation.

Whether you take on this strategy depends on your temperament as an investor. Success requires you to be able to make smart decisions with your satellite approach. Doing this successfully over the long run is very difficult to do.

My thoughts on Core/Satellite

It's hardwired into our brains to want to be part of the herd and to belong. We naturally have action biases and decision making is heavily influenced by emotions. This is outlined in the risk as feelings theory by George Lowenstein, which explains that the emotional reactions often drive behaviour and that those emotional reactions often misperceive risk.
It's incredibly hard to completely deny all those feelings. They’re driven by fear and greed and they cause us to do things that are not in our best interest. It is important that core/satellite is actually linked to your investment strategy, instead of being an excuse to satisfy the part of your brain that wants to maximise wealth.

This concept of having a speculative portion of your portfolio is known as ‘Mad Money’. The notion comes from Benjamin Graham, who has often been described as the ‘Grandfather’ of investing. He explains in Chapter One of the Intelligent Investor that the bulk of your money should be invested carefully, but a little bit of it can be used for speculation. It is used to scratch a speculative itch, without blowing your whole nest egg.

This isn’t too far different from the Core/Satellite approach. The ‘core’ is for your passive foundations. The ‘satellite’ is for your active bets and speculative tilts.

We always recommend that investors create a framework to try to govern decision making so that you are thoughtful and disciplined about your actions. An Investment Policy Statement (IPS) includes criteria and rules that guide your actions.

Having set criteria helps. This can force you to justify that your decision aligns with your overall strategy. Unfortunately, this is not a magic bullet. It doesn’t mean that you won’t get caught up in the greed of some top performing investment. It doesn’t mean that you won’t behave poorly during a bear market and sell your investments.

This is one concern with this approach. If you are an investor who gives yourself an ‘allowance’ of your portfolio for speculative tilts, what if it is temporarily successful? Would you believe that a larger position should be allocated to your speculative tilts, and less to the portions of your portfolio that make up the core?

I believe that if you are able to use it as a tool to serve your investment strategy and your financial goals instead of as a speculative or active bet it has value. For example, I use a variation of the Core/Satellite approach to dilute or concentrate exposure, married with the core exposure of the portfolio.

All of my goals have long time horizons. My retirement has more than 30 years to go. Let’s say that for my core exposure for Australian equities, I’ve chosen a passive investment that follows the ASX 300. Over a long time horizon, I could marry that with a satellite exposure to concentrate that exposure on mid cap or small cap shares, which would dilute my exposure to large cap shares.

This approach can be used in a multitude of ways. You could pick a dividend ETF to tilt your portfolio towards the satellite portion. You could pick a sector tilt. For example, you could own the S&P 500 in your core, and concentrate further with your satellite invested in the NASDAQ 100. There are many options to use this approach.

I am a passive investor. I believe that this is the best approach to reach most of my long-term financial goals. This belief is documented in my investment strategy. Of course, writing something down doesn’t always mean that you believe in it.

If I were to use the Core/Satellite approach to speculate, or try to maximise my wealth, I would have an intellectual disconnect between my strategy and the approach I'm taking. There are many reasons to be a passive investor. Namely, that most people don’t beat the market and your tax and fee impacts tend to be significantly less. Believing in passive investing is different from using passive investments in a non-passive way. If you’re constantly changing your asset allocation or trading one passive investment to another – you are not a passive investor.

This applies to all investors regardless of whether you follow a passive approach. Your investments must align with what you’re trying to achieve. For some investors Core/Satellite may be giving into temptation and get you off track. For others, it can be used as a tool to structure your portfolio for the outcomes you are trying to achieve.

Choose what’s right for you, and avoid the need to label

Investing is a means to an end, and investments are just the vehicles to get you the life you want. One approach may be right for one investor and another for a different investor. Both investors can be successful. Even more commonly, both approaches may be right for an investor – serving different purposes in a portfolio or assigned to goals that have differing objectives.

It's important that investors do not fall into the industry habit of having the label yourself. You do not have to choose whether you are a Core/Satellite investor. You do not need to choose whether you strategically or tactically allocate. You don’t need to label yourself as a growth or income investor. You do not need to choose whether you are a property disciple or a share supporter. These investments are just tools for you to reach your goals – use each tool when necessary and when they make the most sense for you.

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Previous Future Focus columns:

  • Why I use managed funds
  • Why I don't hold cash
  • Why I won't commit to an SMSF
  • Read this before you pick an ETF
  • Every Aussie deserves a fair go with super

Resources mentioned:

  • My disinterest in investments as an investment specialist
  • Morningstar's Guide to Portfolio Construction