The most common method for determining your stock/bond allocation is to base the decision primarily upon your age, then make an adjustment based on your personal tolerance for volatility.

The idea is that, over extended periods of time, stocks are likely to outperform bonds. So the longer your investment time horizon, the more you should have invested in stocks.

But one could (quite reasonably) make the case that the likelihood of stocks outperforming bonds over a given period *also* depends upon:

- Market valuation levels at the beginning of the period, and
- Available interest rates at the beginning of the period.

So wouldn’t it make sense to take those factors into account when determining your asset allocation?

### Estimating Future Returns

Tactical asset allocation strategies seek to estimate the future return of the stock market over your investment time horizon. Then, you compare that estimated return to the return offered by other investments–most notably TIPS due to their predictable returns–and determine your allocation accordingly.

For example, if the expected return that you calculate for the stock market is no higher than the current rate available on TIPS, it wouldn’t make sense to hold very much in stocks. (Why take on the additional risk if there’s no additional expected return?)

To date, the best method I’ve seen for estimating future market returns is the Gordon Equation, which states that inflation-adjusted market returns must equal:

- Dividend yield, plus
- Inflation-adjusted earnings growth, plus (or minus)
- The effect of changes in the market’s P/E ratio.

Because of the compounding nature of dividends and earnings growth, as we look at longer and longer periods, the first two factors become the primary determinants of return. Over shorter periods, however, changes in P/E play the biggest role in determining return.

### Implementation of Tactical Asset Allocation

So how, exactly, should a tactical asset allocation strategy be implemented within the context of an investor’s lifetime? For example, how should you incorporate your age into the equation (if at all)?

My suggestion would be this: The longer your time horizon, the smaller the risk premium you demand. (That is, the younger you are, the smaller the necessary spread between the expected return of stocks and the available return on TIPS.)

Why? Because the longer the period in question, the more confident you can be in the Gordon Equation’s estimate of future market returns. (Reason being that the first two factors–dividend yield and earnings growth–are the more predictable ones. And the longer the period in question, the greater the portion of returns they comprise.)

### Causes for Concern with Tactical Asset Allocation

As much sense as it might make to consider market price levels and market interest rates when determining your allocation, there are a few reasons I’ve been hesitant to implement such a strategy with my own portfolio.

First, regarding the Gordon-Equation-based strategy, there’s always that third factor–changes in the market’s P/E ratio–which simply can’t be predicted with certainty. Even if you can say with a fair degree of confidence that the market is undervalued (or overvalued) there’s really no telling *when* it will correct itself.

Second, no matter what strategy you come up with, it’s going to have a built-in historical bias. That is, it’s going to be optimized to work in conditions that resulted from the chain of events that occurred over the *last* 85 years or so (the period for which we have market data). How well it will work over the *next* 85 years is unknown.

Third, there are numerous funds that implement tactical asset allocation strategies. Yet they don’t appear to make up a noticeably disproportionate amount of top-performing funds. Why is that?