What Is Switching? What It Is, How It Works, & Example

If you've ever played a game of musical chairs, you are probably familiar with the concept of everyone getting up and switching chairs. Just as you switch chairs in the musical chairs world, sometimes you need to switch assets when you invest.

Switching can be an important part of portfolio management. While The Motley Fool does not recommend switching based on short-term market trends, every investor should be well-read on the subject, regardless of whether music is playing in the background.

Overview

What is switching?

Switching is the process of moving assets from one investment to another. This can involve selling one stock and buying another, moving funds between different mutual funds, or reallocating assets across various sectors or asset classes. The goal of switching is typically to optimize returns, manage risk, or take advantage of changing market conditions.

How it's used

How switching is used

Switching can be a tool for investors looking to adjust their portfolios in response to market trends, economic changes, or personal financial goals. Here are some common applications of switching:

Portfolio rebalancing

Switching is often used to rebalance a portfolio. Over time, the performance of different investments can cause the original asset allocation to drift away from its target. For example, say you originally planned to invest in high-growth emerging markets like China. However, due to a bad economic situation, you might change to another country like India or Vietnam. By switching assets, you can realign your portfolio to your desired risk and return profile.

Taking advantage of market opportunities

You may switch investments to capitalize on new market opportunities. For instance, if a particular sector or technology is expected to outperform, you might switch from underperforming stocks or funds to more promising investments.

One example is the rise of computer chips that are associated with AI. Companies like Nvidia (NVDA -1.62%) and Taiwan Semiconductor Manufacturing Company (TSM 0.44%) have become attractive investments due to their crucial role in producing the advanced chips required for AI applications.

Risk management

Switching can also be a strategy for managing risk. By moving assets from higher-risk investments to more stable ones, you can reduce your exposure to market volatility, especially during uncertain economic times. For example, in tumultuous times, capital flows from all over the globe into U.S. Treasury bonds. Likewise, in times of uncertainty, switching to low-yielding yet ultra-safe assets can be a wise play.

Key considerations

Key aspects of switching

Switching involves several critical considerations that provide comprehensive insight into a company’s financial commitments:

Strategies

Types of switching strategies

Different strategies can be employed for switching investments:

Rotating investment sectors

Sector rotation involves switching investments between different sectors based on their performance cycles and economic conditions.

For example, during the COVID-19 pandemic, many investors moved assets from traditional sectors like retail and travel to technology and healthcare, which were expected to outperform due to the increased demand for medical services and remote work solutions. Companies like Moderna (MRNA 3.01%), which developed a successful COVID-19 vaccine, and Zoom (ZM 1.43%), which provides video conferencing software, saw significant investment as they played critical roles during the health crisis. This shift allowed investors to capitalize on booming demand in these sectors while mitigating risks associated with industries like food and beverages that were taking a beating.

Tactical asset allocation

Tactical asset allocation involves switching between asset classes, such as stocks, bonds, and cash, based on market conditions. This strategy allows investors to take advantage of short-term opportunities while maintaining a long-term investment strategy. For instance, in the aftermath of the 2008 financial crisis, many investors increased their holdings in bonds and reduced exposure to equities to protect their portfolios from further losses. As markets began to stabilize and recover, these investors gradually shifted back into equities to capitalize on the recovery and potential growth opportunities.

This can also be applied to changes in the interest rate environment. Since interest rates were held close to 0% for a long time after 2008, much of the money available was chasing yield in the form of stocks and corporate bonds. However, when the interest rates increased, many investors chose to put their money into high-yielding, super-safe assets, like Treasury bonds and money market accounts.

Fund switching

Fund switching is common in mutual fund investments, where investors move money between different funds offered by the same fund family. This allows investors to adjust their risk exposure and investment focus without leaving the fund family.

For example, you might start with a conservative mutual fund focused on bonds and fixed-income securities. But if your risk tolerance or the market outlook changes, you might switch to a more aggressive fund focused on equities to pursue higher returns.

Is it worthwhile?

Is it worth it to use switching strategies?

Switching strategies can be highly beneficial, but just like everything in life, they come with downsides. The primary downsides include costs associated with transactions, potential tax implications, and the need for ongoing monitoring and management. The other downside is investors chasing shiny new objects and not concentrating on their original portfolio strategy. The Motley Fool recommends long-term investing strategies based on a personalized thesis rather than pivoting based on short-term market trends.

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Example

Example case: Switching in action

Let's give the example of an average investor reading the news that the technology sector is expected to experience significant growth due to new innovations that let machine learning create a much more efficient product. To take advantage of this opportunity, the investor decides to switch a portion of their bond investments into a technology-focused mutual fund.

Timing: The investor analyzes market trends and economic indicators to determine the best time to switch. They believe the third quarter is the best time to switch.

Costs: The investor considers transaction fees and potential tax implications of selling bonds and buying mutual funds. They usually break down the scenario via a model to gauge the predicted ROI vs. cost.

Impact on portfolio: The investor evaluates how this switch will affect the overall risk and return profile of their portfolio. If the investment complements their overall portfolio strategy, they might be much more willing to switch.