One term you’ll often hear about when discussing various investment strategies is “tactical allocation.” It refers to an approach that attempts to capitalize on investment opportunities in rising, flat, and falling markets. The potential for tactical allocation is an intriguing alternative to passive management that relies on time to produce results. This is particularly true when considering the allocations of large and small-cap stocks in portfolios with different risk characteristics.
This blog will delve into the subtleties of tactical allocation between these two diverse types of stocks to provide a fresh active management perspective for independent Registered Investment Advisors (RIAs) and Investment Advisor Representatives (IARs).
Read our newest Quick Guide, “An RIA’s Definitive Guide for Tactical Asset Allocation.”
Understanding the Subtle Differences between Large and Small Capitalization Stocks
In the investment world, it is important to understand the critical differences between large and small stocks. These companies are categorized based on their market capitalizations – that is, the outstanding shares of stock times the current price.
Large-cap stocks like Apple or Microsoft have billions or trillions of stock market capitalization. These giants are brand-name companies that dominate their particular industries. Not to mention: Stable management, solid balance sheets, profitable businesses, and solid markets with recurring demand.
On the other hand, small-cap companies, with market capitalizations ranging from $300 million to $2 billion, are usually newer businesses with significant growth potential. They are often considered riskier than large-cap stocks due to their more volatile earnings, reduced resources, and increased susceptibility to economic downturns.
The differences between large and small-cap stocks don’t stop at size or stability. These disparities significantly affect investment strategies, particularly regarding tactical allocation.
Tactical Allocation between Large and Small Cap Stocks
Tactical allocation is synonymous with active portfolio management, moving assets in and out of stocks, industries, and other criteria that impact the performance of their stocks. In this context, large-cap and small-cap stocks play different roles in active portfolio management.
Given their increased stability and predictability, large-cap stocks are typically the cornerstone of any investment portfolio. Their steadier returns and reduced volatility can provide a safety net during periods of market volatility. This prominent visibility and dependable revenue streams add a layer of security for equity investors, making them an attractive part of any tactical allocation strategy.
Small-cap stocks, on the other hand, are often the growth engine in a portfolio. That is the expectation, in particular for companies experiencing rapid growth. However, the flip side of higher growth rates is bigger price fluctuations during stock market volatility. This risk-reward dynamic makes small-cap stocks an important part of tactical allocation for investors willing to tolerate higher levels of risk for the potential of higher returns.
Tactical Allocation Strategies for Large vs. Small Stocks
Tactical allocation is not a one-size-fits-all approach, and different strategies can be utilized based on your understanding of your client’s investment expectations and tolerances for risks.
Here are some strategies to consider:
- The most frequently used strategy, based on diversification to manage risk, involves allocating investments across large and small-cap stocks to manage risk (large caps) and generate higher returns (small caps). For example, an all-equity portfolio for a moderate-risk client could allocate 65% of the portfolio to large caps, 30% to small caps, and 5% to cash equivalents.
- Market timing involves the willingness of the portfolio manager to move assets from one asset class to another based on market outlooks for future performance. For example, when the economy is strong, and interest rates are low, it might make more sense to increase allocations to small caps to capture their higher returns. Conversely, it could be wise to pivot during a downturn to more stable, large-cap stocks with the balance sheets that companies need to weather storms.
- Sector Rotation involves moving investments from one industry group to another based on economic indicators. For example, small-cap stocks in cyclical sectors like consumer discretionary or technology may perform better during faster growth and economic recovery.
- With pair trading, in this strategy, an investor would buy a stock they expect to perform well (say a small cap) and short a related stock they expect to underperform (say a large cap). This strategy relies heavily on thorough research and a strong recommendation for the paired stocks.
Tactical allocation between large and small-cap stocks can be an effective tool for independent RIAs, IARs, and Broker-Dealers. However, like any investment strategy, it requires careful consideration and understanding of the potential rewards and risks.
Successful investing requires due diligence, patience, and adapting to ever-changing market conditions. By demystifying these processes, one can be better positioned to craft a strategy that balances stability with growth, optimally managing the dynamic interplay between large and small-cap stocks.
How Cornerstone Portfolio Research Assists Independent RIAs and IARs with Tactical Asset Allocation!
As an Outsourced Chief Investment Officer (OCIO), we provide highly sophisticated investment research and portfolio management services to independent Registered Investment Advisors (RIAs) and Investment Advisor Representatives (IARs). We offer the benefit of deep expertise, multiple CFA® Charterholders, and sophisticated tools that may not be readily available at your firms.
Our OCIO services can provide market research, economic forecasting, tactical asset strategies, and risk/reward models. We analyze trends and cycles, providing actionable recommendations that can help your RIA provide active management that maximizes returns and minimizes risks over longer periods.
When you partner with Cornerstone, you can also leverage economies of scale to access a broader range of investment opportunities that, as an independent RIA or IAR, you may need to maintain your competitive edge. These include alternative investments, global investment markets, and niche asset classes.
We also assist by reducing your operational burdens. We take on time-consuming portfolio management tasks such as trading, reporting, rebalancing, and investment-related compliance. This gives you more time to add new clients and spend more time with current clients.
As your OCIO, we can bring objectivity and discipline to decision-making, helping to minimize behavioral biases that can lead to bad investment decisions. The rigorous process that Cornerstone employs can contribute to more consistent and potentially better investment performance. Connect with us today to learn more about our tactical asset allocation services.
