How should I invest my Thrift Savings Plan balance?
This is a question I hear regularly from TSP participants, both before and during retirement. And, while I
could toss out rules of thumb or formulae galore to try to answer the question, I must, in good conscience, respond with the always frustrating “it depends.” As my best answer, I will describe for you the process that is necessary to properly develop an investment strategy. This process can be used on an individual account, like the TSP, with some success, but it is most valuable when applied to your investment resources in total.
The first step is to develop a financial plan. Your TSP account and other investments are means to an
end — your financial success. The strategy you choose for investing your assets should depend on what
you want those assets to accomplish. Most investors I’ve worked with, after careful consideration, want
their financial assets to support their desired lifestyles and other goals, such as retirement at a certain
age with income to support certain spending levels.
Interestingly, when investors attempt to select an investment strategy without the benefit of a financial
plan and the associated package of life-related goals, they usually search for one of two things: maximum potential investment return or minimum short-term volatility. The problem with these two priorities is they often fail to support the investor’s true goals. This approach makes the investment strategy, and its results, the end rather than the means. I can’t count the number of times clients have come to me seeking one of these two investment extremes, only to change their minds once they realize the benefits of a comprehensive plan.
Comprehensive planning should include recognition that future investment results, inflation rates and life
spans are variable and unpredictable. Assuming that an investment portfolio will deliver its expected
average rate of return like clockwork each and every year of a plan’s duration can lead to disastrous
results. Assuming that a client will live to a certain age can, if too young, lead the client to overspend, or if too old, lead the client to sacrifice her goals during her lifetime and leave excess wealth in the end.
An analytic technique has been designed to accommodate these and other uncertainties. It’s called
Monte Carlo simulation and it should be used to develop your financial plan. A word of caution, however:
Monte Carlo simulation is a complex tool for use in analyzing probabilities. Its results and their value
depend heavily upon the assumptions and inputs used by the analyst. Some studies have shown that
many professionals are misusing Monte Carlo simulation and producing unreliable or misleading results.
Use care in selecting an analyst and avoid doing Monte Carlo simulation yourself.
One of the results produced by the simulation will be the required performance characteristics for your
investment portfolio — the amount of return and risk required to make your financial plan workable.
Ideally, this portfolio will deliver enough return to make your plan work without subjecting you to
unnecessary risk. That should be your goal: no more risk than necessary to get the job done. The Monte
Carlo simulation modeling has tested the results against the range of negative outcomes likely to occur
using the given portfolio.
The next step is to design a portfolio that will produce the risk and return characteristics called for by the
plan. This, like Monte Carlo simulation, is as much art as science. The goal is to produce a reasonably
efficient portfolio that fits the bill. Efficient portfolios are combinations of assets that deliver the maximum
return possible for a given level of risk. A competent financial planner can do this for you, or you can
search online for any of a large number of more or less efficient asset allocation models used by brokers
and retirement plan custodians.
I presume that the asset allocation models for the TSP’s planned L Fund will be a good place to start for
TSP investors. Under the L Fund, or Lifecycle Fund, a company will decide what percentage of an
enrollee’s contribution should be invested in each of the five other funds offered in the TSP. Those who
are 10 or 20 years away from cashing in their TSP accounts will have more of their contributions invested in stocks, which are more volatile but yield larger savings in the long run. As an enrollee nears retirement, the allocation will automatically shift so more of the contribution is placed in safer funds tied to bonds and securities.
Ultimately, though, what you need is an allocation — for example, 40 percent large cap domestic stocks,
20 percent small cap stocks, 10 percent foreign stocks, 20 percent bonds and 10 percent cash — that will efficiently meet the need of your financial plan
The securities used to build this portfolio, to be efficient, should have certain characteristics. They should
be well diversified. They should carry the lowest possible expenses. They should be easily traded, simple to understand and convenient to manage. Fortunately, the TSP’s funds have all of these characteristics — something few alternatives can match. As index securities, the TSP’s funds passively follow broad collections of market securities, stocks and bonds. Turnover and costs are extremely low. Diversification is excellent. All of this means that the funds deliver high levels of return in exchange for the risk they carry. It is important to understand that any efforts to beat the market — for example, by market timing — would only add risk and cost without any corresponding increase in expected return, and should be avoided.
Finally, you should periodically review your plan and portfolio and make adjustments as necessary.
Hopefully, this outline will help guide you in your investing efforts or in your search for professional
Written by Mike Miles
For the Federal Times
Publication May 16, 2005