If you have any of your TSP account invested in the C, S or I Funds, you should be nervous. Why? Not because of the Ebola virus, turmoil in the Middle East, the National Debt or legislative gridlock. Sure, those are all significant threats to various interests in various ways, but, whether you realize of not, the threat those pose to stock values are already reflected in the share prices of the various TSP funds. Professional investment managers are not paid to wait for bad things to happen before responding. They are paid to predict the probabilities of future events and respond to opportunities and threats in advance – which they do.

The reason to be nervous about stock prices, here, is simple: Stock prices are near their all-time highs and have advanced ahead of expectation for the better part of 5 years. As prices rise, the risk of loss increases. Declines in stock prices are inevitable. Unfortunately, the timing and magnitude of those losses is impossible to reliably predict.

The fact that you’re invested in any of the TSP’s three stock funds should indicate that you expect to need the returns they can produce to meet your lifetime financial goals. If you can achieve your goals with less risk, then why wouldn’t you take the safer route? But needing the greater return means that the “right” portfolio will include some exposure to stocks and the risk of loss they bring. If this is the case, then any portfolio allocation that does not include stocks is “wrong” for you.

Going back to the basic nature of stock losses; their inevitability and unpredictability mean that if you’re in the right portfolio, and that portfolio includes stocks, you will suffer losses from time to time. As an investment manager, you must accept this fact. Unfortunately, many do not and they futilely attempt to avoid losses by abandoning the right allocation in favor of a wrong one. This is an example of a rational fear – the fear of losing money – leading to an irrational action: Exchanging the right portfolio allocation for a wrong one. The move is  irrational, because it is made in an attempt to avoid the unavoidable.

Let’s look at this from a logical perspective. If you’re in the wrong portfolio, your financial plan will fail. If you you’re in the right portfolio and it includes stocks, you will lose money from time to time. But, does losing money equal failure? This depends upon how you define failure. If your only objective is to avoid losses, then losing money equals failure. But, if you define failure as failing to meet your lifetime spending and wealth objectives, then the two are not necessarily synonymous. If your financial plan relies on never losing money to succeed, and you must also invest in stocks to succeed, then you have a serious problem. You can’t invest in stocks and reliably avoid losses, so the two are mutually exclusive.

The solution to this problem is to 1. Minimize the risk of loss by limiting your exposure to risky assets to only that which is necessary to support your lifetime financial goals, 2. Minimize the risk posed by these assets by properly diversifying them, 3. Develop and manage a spending plan that will tolerate the inevitable losses without failing, and 4. Maintain the properly diversified – “right” – portfolio asset allocation at all times.

This means never moving to the “wrong” allocation to avoid losses, which is an inherently irrational tactic. Consider the risks that you take on when you make such a move. You’ve moved to the wrong allocation, so you’ll need to move back to the right one, eventually, or doom yourself to certain failure. How long can you afford to wait? What if you wait too long? When will you get back into the right allocation? If you pick a specific time, what if that time is wrong? If you pick a particular signal, like a lower price level, what if that level is never reached? Without a solid plan for subsequent action, moving to the wrong allocation isn’t part of a strategy at all. It’s like jumping out of an airplane without a parachute in response to a sudden loss of altitude. The questions you’ll have to answer after you jump out are probably tougher than the ones you’d have faced if stayed aboard. Fear in this situation is reasonable. It’s what you do in response to the fear that deserves careful consideration.

Written By Mike Miles
For the Federal Times
Publication October 27, 2014