Ask a group of Thrift Savings Plan investors to give you a definition of investment risk and you’ll get a variety of answers. One of the most common answers I’ve heard over the years defines risk as “the possibility that my account value will drop dramatically next year.” This definition of risk can lead investors to make poor investment decisions, such as investing too much of their balances in the low-returning G or F funds.
I suggest you adopt the following definition of investment risk for your TSP account: Investment risk is the probability that my investment account will be worth less than expected at a future point in time.
Most TSP participants expect their accounts to support a stream of spendable income during their retirement years. The size and duration of this stream of income is directly related to the size of the account during those years, which is, in turn, the result of investment returns earned before and during retirement. Projecting spendable income in retirement would be a simple process — if investment returns could be accurately predicted.
While the calculator available at www.tsp.gov will do the job for you in exchange for a few pieces of information, its projections require assumptions about the growth rate for your account balance. Enter a value, say 10 percent, and the calculator will give you a result.
The problem with this method is that investment returns vary from year to year, and the growth rate realized in your account may vary from the rate you expect. If the realized rate is lower than the projected rate, you’ll be forced to make downward adjustments in your retirement spending — an event that any reasonable participant would prefer to avoid.
Using the definition of risk I recommend will lead you to focus your investment management efforts on maximizing the predictability of achieving the desired growth rate in your account, rather than avoiding short-term volatility or chasing maximum return without regard to downside risk.
Diversification is the key to reducing investment risk, as I’ve defined it, and maximizing the likelihood that your TSP account will produce the rate of growth you expect and need to support your retirement plan. There are three basic types of diversification that you need to be concerned with:
- Time diversification, the concept of holding an investment over more, rather than fewer, time periods.
The benefit of time diversification is that it reduces the risk of being in the market at only the wrong time — a mistake that sharply increases investment risk. Think of it this way: If you invest $1,000 in the C Fund, for example, for one year, the investment return you realize from this investment may vary widely. While you might reasonably expect a 10 percent return, the actual return might be a loss of 15 percent. But, if you hold an investment in the C Fund over, say, 30 years, it is much more likely that the average annual rate of return will be closer to 10 percent than it was for the one-year holding period.
This is why attempting to “time” your investments in the TSP is a bad idea. Jumping from one alternative to another effectively shortens your holding period in each fund and increases the risk that your account will be worth less than you expect when you need it.
- Intramarket diversification, the practice of holding many securities within a particular market at one time.
This strategy reduces security-specific risk — the risk that an investment in any one security — a company stock, for example — will be worth less than expected in the future. This type of risk is the result of factors specific to a particular company, like management error or dishonesty, and not to factors common to entire industries or markets.
Intramarket diversification is best accomplished by index investing, a technique that is built in to every TSP fund by design. All you need to do to reap the benefits of intramarket diversification is to take advantage of any of the TSP’s five funds.
- Intermarket diversification, accomplished by holding securities from multiple markets — markets that tend not to behave in exactly the same ways at the same time. The ultimate example of intermarket diversification in the TSP is to invest in all five of the funds at once.
The advantage of this practice is that it reduces market risk — the risk that a particular market or industry will move against you. If stocks are down, bonds may be up and help to reduce your losses. Or bonds may be down and foreign stocks may save the day.
In other words, spreading your account balance around will help to increase the likelihood that your account will be worth what you expect it to be worth at any given time in the future.
Intermarket diversification is accomplished through asset allocation — divvying up your account balance among the five TSP funds. Again, TSP has this type of diversification covered: The new L Funds have been designed to maximize the benefits of intermarket diversification and provide a convenient way to improve your odds of achieving your retirement goals.
Written by Mike Miles
For the Federal Times
Publication March 27, 2006