Steve Jobs’ premature death reminded us all of many important things, but one, to me, stood out among others: the potential for resurrection. Jobs’ fortune rose with the founding of Apple and launch of the Macintosh computer in 1977, fell with his 1985 departure from Apple after a bitter falling-out with CEO John Sculley, and rose again with his 1997 return to the company and creation of one innovative digital device after another. What goes up must come down, it’s often said—but Jobs illustrated that what goes down can also come up again. And that’s not unlike the financial markets.

Market volatility, it seems, is the new normal. The S&P 500 Index had nearly as many plus or minus 4 percent trading days from 2007 to 2010 (40) as the previous 57 years combined (38).


Financial professionals disagree about why. The past few years have been turbulent, economically speaking, and that can impact the financial markets, which consist of thousands of stocks that fluctuate with economic news. Others might argue that volatility has been precipitated by the rise of electronic trading in the 1990s and the 2007 demise of the uptick rule, which forced traders to wait for a stock’s price to rise before shorting it.


Regardless of the cause, one thing is certain: Market volatility is so prevalent it’s now a tradable product, with asset managers around the world making fortunes on the rise and fall of the financial markets.

Of course, volatility isn’t always good, in markets or in public figures. Jobs’ career went down and came up; entertainers’ careers often go down and stay down, as Charlie Sheen has recently demonstrated. Entertainers are quickly replaced, but assets aren’t. That’s why, in investing, it’s important to have a strategy for dealing with market volatility.


To many asset managers, the best strategy for managing volatility is diversification. Because different types of securities perform differently at different times, the theory holds, investing in a mix of asset classes increases one’s chances of obtaining a compelling total return. When some asset classes decline, others may rally, creating a cushion for the overall investment portfolio. During the 1980s and 1990s, few individual investors questioned this strategy, and for good reasons: While volatility clearly existed, it was fairly manageable, and markets recovered quickly.

This strategy has always presented some problems, however, as evidenced by the challenges of the past decade. We’ve seen two significant recessions since 2000. Equity returns have been sluggish, and many now refer to 2000 to 2010 as a “lost decade” because the S&P 500 Index’s 10-year return turned negative for the first time since the 1930s.


If investors take one thing away from the market turbulence of the past four years, it should be the importance of maintaining flexibility in one’s asset allocation—both in order to manage downside risk and take advantage of new opportunities. That’s why I believe in a tactical allocation strategy, which allows for the timely rotation among asset classes in a risk-controlled framework.


I know I risk getting too technical here, so if your eyes glaze over at the mention of the word “mean reversion,” or if you just like Mark Hamill, skip to the last paragraph. Otherwise, consider this: Asset prices consistently deviate from fundamentals based on investors’ perceptions and expectations. Yet, there’s considerable evidence that asset prices will, over time, return to fundamental levels. This is the basis of tactical allocation. In an attempt to uncover opportunity and mitigate risk, tactical portfolio managers systematically exploit changing market conditions by moving assets between classes (including cash, ideally). They often do so with an understanding of relative strength, which I recently explained in my post about fantasy football, using technical analysis to identify price momentum (which we also call trend following, another topic about which I recently wrote).

In sum, a buy-and-hold strategy may be viable in a bull market where downswings are short or you have lots of time—but sometimes we don’t have the luxury of waiting for markets (or public figures), to recover. It took 25 years for the Dow Jones Industrial Average to recoup its losses after the height of the Great Depression in 1929. Investors needed their portfolios to gain around 60 percent just to break even after the S&P 500 Index’s 37 percent loss in 2008. And a friend of mine is still waiting for the comeback of Mark Hamill, who hasn’t enjoyed anything near the fame Star Wars’ popularity suggested he would.


Why wait? Isn’t tactic allocation a better idea?