Recently we met with a prospective client in our office who offered an opinion that surprised us.

“I don’t really believe in asset allocation,” he said. “It certainly hasn’t worked for me.”

This particular individual is a savvy investor who sits on a large block of concentrated stock. He understands the inherent risk of being so heavily invested in the fate of a single company, but he didn’t see a lot of benefit to diversifying, either. He viewed both situations as equally risky.

On the surface, this didn’t make sense. How could diversifying one’s assets across dozens of market sectors and thousands of securities be equally as risky as having everything riding on the fate of a single company?

When we pressed this gentleman for more information, however, we quickly understood where he was coming from:

He had been the victim of tactical asset allocation.

Tactical asset allocation is a strategy in which an investment manager diversifies his clients assets across a wide variety of asset classes and investment styles and then – herein lies the problem – shifts the money around periodically according to the advisor’s opinions about where the “opportunities” and “dangers” lie.

Those opinions are invariably based on market trends, economic forecasting, timing systems, or just plain hunches. But whatever the underlying rationale, the result of tactical asset allocation is the same: It introduces a huge risk into the equation – the risk of bad guessing.

That’s what happened to the aforementioned investor. His advisor had diversified his assets and then set about guessing which sectors to “overweight” and which sectors to “underweight.” Unfortunately, he guessed wrong, and it cost his client plenty.

This is not unusual; in fact, it is quite common, especially in times of extreme volatility. Consider this: How many investment professionals correctly called the financial market meltdown of 2008 and moved their clients’ assets into the correct market sectors to avoid that meltdown? Perhaps there are a few, but they certainly are keeping a low profile.

And how many of those same professionals saw, in March 2009, the beginning of one of the greatest market recoveries in the last 100 years and correctly overweighted their clients’ assets in the highest gaining asset classes? Did anyone really have the guts to overweight REIT and emerging markets value stocks in March ’09, with those two asset classes down more than 70% over the prior 12 months? Anyone? Hellllooo…?

Tactical asset allocation is the evil twin to strategic asset allocation – the cornerstone of our investment philosophy at Capital Directions. Strategic asset allocation advocates combining poorly correlated asset classes together in a portfolio to diminish unnecessary risk as much as possible. It is pure common sense – “don’t put all your eggs in one basket” – with a strategic foundation.

An advisor who adheres to strategic asset allocation would never shift around a client’s assets according to past or predicted future market conditions. Instead, changes to the allocation are based on changes in the client’s life situation.

Strategic asset allocation isn’t a panacea. It can’t keep you from experiencing market volatility, although it can certainly diminish unnecessary volatility. But the real benefit of strategic asset allocation is that it removes the risk of bad guessing and keeps the client invested so that he is there when the market makes its sudden and unexpected moves upwards. Like the 70% gain the S&P 500 has logged in the past 12 months.

When an advisor touts the virtues of “asset allocation” or “diversification,” that is really only the opening statement. It is vitally important for investors to then drill down and ask that advisor whether he practices strategic or tactical asset allocation. Or, at the very least, whether he shifts his clients’ assets around based on his beliefs about where the market is heading.

The answer to that question will tell you whether you want to continue your discussions with that advisor – or run screaming in the other direction while you still have your wealth intact.