Market volatility refers to the extent to which the market price, or value, of investment assets change over a particular period of time. For my purpose here, it refers to the extent of change in share prices, and position values, of the TSP’s investment funds. The wider the range of price, or value, from high to low, during a given period of
time, the greater the volatility. In general, the G Fund should be the least volatile of the TSP’s funds, and the S Fund should be the most volatile of the lot. Between them, in order from most to least volatile, should be the I Fund, the C Fund and the F Fund. So, from most to least volatile: S, I, C, F and G.
Volatility is a fact of life for investors in risky securities, and all of the TSP’s funds are risky in that their future share prices, and values, are not known, in advance. With the G Fund, you know its future value will always be greater than or equal to its value today, but you don’t know exactly what that value will be. The other 4 basic TSP funds all
carry the risk of loss. That is, the risk that the value of a share, and of your position in the fund, will be lower in the future than it is today.
Gamblers and speculators love volatility. Volatility is what makes big gains over short periods possible. Without high volatility, striking it rich is impossible. Retirement investors hate volatility, or at least they should. Volatility is the enemy of high and sustainable rates of withdrawal. When your taking withdrawals from your TSP account to support your standard of living in retirement, taking a withdrawal against a reduced account value does damage to the future withdrawal stream that must be repaired. If all other factors are equal between two investment strategies, the less volatile strategy will support a higher lifetime withdrawal rate than the more volatile strategy.
Since the TSP is intended and designed to help retirees produce retirement income, I will let the gamblers and speculators fend for themselves, and focus on investing for retirement. While the bad news is that volatility can’t be entirely avoided, the good news is that it can be effectively managed.
As I’ve proposed many times over the years, managing an investment portfolio is a lot like flying an airplane. And, ignoring investment volatility is like flying that plane 50 feet off the ground. When a downdraft affects your plane, you’re going to hit the ground. When volatility affects your portfolio you’re financial plan is going to fail in some way. Only, you’ll know immediately when your plane crashes, but you won’t know for some time, maybe decades, that your plan is doomed to fail.
What this analogy should make clear is that once the volatility has happened, it’s too late to do much about it. The damage has been done. The time to protect yourself from the volatility is before it happens. You fly the plan with enough altitude to ensure that any turbulence can be absorbed without resulting in a crash. Rather than ignore the potential for volatility, or pretend that it can managed after the fact, you must accept that it is a risk and design your financial plan to withstand it. Your plan should not depend upon avoiding all volatility, but should seek to minimize it, and then succeed in spite of it.
This is accomplished in a couple of ways. First, your investment portfolio should be configured to deliver the returns you will need to fund your lifetime withdrawal needs with a minimum of volatility. This is, in turn, accomplished through the use of diversification. Much of the diversification work has been done for you by the TSP’s funds, themselves, but you’ll need to make sure that your portfolio is properly allocated among the appropriate funds at all times. One of the best defenses against stock market volatility is to hold bonds – the F Fund – along with the C, S and I Funds.
Second, your plan should leave sufficient margin for absorbing the volatility that your asset allocation is likely to produce. That means planning to live well within your means. If your plan requires that you earn the expected return from you investment portfolio each and every year to succeed, then you are doomed to fail from the start.
If you do it right, there will be no need to worry, or act, when volatility occurs. The answer to the question: “What should I do?” will be “It’s already been done.”
Written By Mike Miles
For the Federal Times
September 14, 2015