As a Thrift Savings Plan participant responsible for managing your own pension fund, you would be wise to understand investment diversification, which means allocating your money among different investment assets – putting your eggs in many baskets.

Why diversify? The usual answer – to reduce risk – is only part of the answer. The real reason to diversify is to improve – or better yet, optimize – your portfolio’s risk-adjusted expected rate of return, which is the rate of return your portfolio is most likely to produce in the future, adjusted for the risk that it will fail to produce that rate or return.

For example, a portfolio with a 10 percent probability of producing a 20 percent rate of return has a considerably lower risk-adjusted expected rate of return (RAEROR) than one with a 90 percent probability of producing a 10 percent rate of return. The former might produce its expected return, while the latter probably will.

Diversification is instrumental to maximizing the probability that you will earn a given rate of return from your portfolio. Optimizing the risk-adjusted expected rate of return is the process of identifying the rate of return you will need to support your lifestyle in retirement and then combining various types of investments to maximize the probability of actually achieving that required rate of return.

Every investment portfolio has an expected rate of return and associated probabilities, and an infinite number of alternative rates. As an investment manager, it is your responsibility – in fact, it is critical – to know what those rates and probabilities are for your portfolio.

For our purposes, there are two basic types of diversification: intramarket and intermarket. Intramarket diversification occurs within a particular market or group of investments, while intermarket diversification occurs among two or more investment markets or groups.

Let’s start with intramarket diversification, something the TSP takes care of automatically.

If you own stocks or bonds issued by a single entity, there is a potentially large risk that the issuing entity will falter or fail to perform as expected. Intramarket diversification can help to insulate you from this risk without costing much in the way of expected rate of return.

If you own the stock of two large computer hardware manufacturing companies, for example, they both probably have about the same expected rate of return. If each stock has a 10 percent expected rate of return, combining them into a portfolio will produce the same 10 percent expected rate of return. But by owning both stocks, the potential for losses resulting from problems specific to one of the companies – say, accounting fraud – is reduced.

So, combining these two assets together in the portfolio did not reduce the expected rate of return for the portfolio, but, at the same time, it reduced at least one type of risk, producing an improved RAEROR.

Taking this logic to the extreme, you can maximize the RAEROR for a portfolio composed of large computer hardware manufacturing companies by owning all such companies. This will minimize the company-specific risk you bear without substantially reducing the portfolio’s expected rate of return.

The same principle can be expanded to larger groups of investment assets, with similar results, and is the part of the rationale for investing in index funds like those offered in the TSP. The TSP’s funds tend to produce high RAEROR values for the types of investment assets they represent – cash, bonds and stocks.

Based on historical evidence, I estimate that large-cap domestic stocks will most likely produce a return of around 12 percent in any given year, before investment expenses. This expectation applies to all largecap domestic stocks, individually and as a group. But history also tells us that there is about a 17 percent chance that, as a group, they will produce a loss of at least 6 percent in any year. Owning less than the entire group of large-cap domestic stocks will produce the same 12 percent expected return, but with higher probability of loss, owing to the increased company-specific risk associated with owning fewer than the maximum number of stocks.

The TSP’s C Fund gives you the optimal large-cap domestic stock exposure – or something close to it – with about the highest RAEROR for the asset type you will find. Any alternative you consider should be compared with this standard.

The same is true of the TSP’s other four basic funds with respect to the asset types they represent.

In my next column, I’ll explain intermarket diversification.

*Written by Mike Miles
For the Federal Times
Publication September 27, 2010*