The election has demonstrated how difficult it can be to predict the effect of world events on the investment markets. If there was a consensus on the effect the outcome would have on the markets, it was that a Trump victory would be bad for stocks.
But, while the stock market did drop significantly immediately following the news that Trump had won, by the end of the following day, it was in positive territory and continuing to climb. During the following weeks, several major stock market indices went on to reach new record highs.
Ahead of the election, I did not hear a single investor suggest that, or even ask if, they should shift their TSP accounts more heavily into stocks. Many investors did tell me, however, that they were considering shifting everything into the G Fund to avoid the possibility of loss. I continue to hear similar questions as we approach the inauguration in January.
Your investment decisions should always be carefully engineered to support your financial goals. There are, basically, two types of financial goals: long-term and short-term. Short-term financial goals are those that rely more heavily on avoiding temporary loss than realizing return to be achieved. Short-term goals are more “sensitive” to risk than return. Achieving long-term goals depends more heavily on realizing a certain return than on avoiding temporary loss. Long-term goals are more “sensitive” to return than risk.
Because you may not have the time needed to recover from a loss before you’ll need your money, funds that are intended to support a short-term goal must be protected from the risk of loss, at the expense of potential for return. The funds you’ll need to support your long-term goals don’t need this protection since temporary losses are likely to be more than recovered over long-enough time periods, and, although unpleasant, are not a threat.
Chances are that your TSP account contains money that will be needed to support your long-term goals. If not, it may be appropriate to invest most, or all, of your account in the G Fund. If so, then some or all of your account should be invested in a combination of the C, S, I, F and G Funds. This is what’s known as asset allocation – distributing your account among stocks, bonds and cash – to properly balance the risk of loss with the potential for return.
Asset allocation, when properly executed, produces a portfolio that is more than the sum of its parts. It produces the greatest expected return possible for a given level of risk. At the same time, however, it accomplishes something else. Asset allocation creates pools of funds that are invested according to time horizon, or the time remaining until you will need the funds to achieve their expected value. Longer time horizons allow for more risk and will generally require less protective cash in the asset allocation. As you age and the short-term goals for your portfolio increase, you should shift to less risky asset allocation schemes with more protective cash. This cash protects you from losses that you can’t afford, while also providing the cash you’ll need to support your goals along the way.
If your TSP account is properly invested, then there should be nothing to do in anticipation of any external event. The correct asset allocation for your TSP account should depend entirely upon your financial goals and should be independent of external events. Maintaining this allocation scheme hedges the risk of each of the individual funds and balances the short- and long-term risks you face. When stocks fall, bonds tend to rise, and vice versa. Rather than betting everything on one spin of the wheel, a diversified portfolio spreads your bets around so that your losses are limited – ideally to an amount that you can afford.
The correct asset allocation scheme, by its definition, minimizes total risk. Shifting to a more conservative allocation will increase the risk of failure to earn the required returns over the long-term. Shifting to a more aggressive allocation increases the risk of losing the resources you’ll need to fund your short-term goals. In either case, the total risk you’ll face is increased. While it might feel as if you are reducing risk by seeking temporary shelter in the G Fund ahead of a headline, you may simply be ignoring the risk of failing to achieve your long-term goals in favor of avoiding the risk of suffering an unpleasant, but innocuous temporary loss.
Written by Mike Miles
For the Federal Times
Publication December 5, 2016