Do you know what your investment objectives are? This is a question that far too many — actually, I believe nearly all — investors fail to answer before seeking or accepting advice about how to manage their retirement portfolios.

Most basically, every investor needs to decide how much of the portfolio to devote to equity, debt or cash — the most basic types of investment assets. Within these three classes are ever-changing arrays of choices — sectors, industries, securities and so on. Which ones to buy? How much to invest? When to get in? When to get out? These are important questions that must be answered, and the answers depend on what you expect your investment portfolio to do for you.

While I can’t give you specific investment advice in a newspaper article, I can give you some general guidance that I think will be helpful. Your investment objectives tend to change significantly with your time horizon — the time you expect your money, or a certain part of it, to remain invested, undisturbed by withdrawals.

Take, for example, a worker who starts a federal career at age 25, works 30 years and then retires at age 55. If that worker is age 25 today and male, he has about a 50 percent chance of living to at least age 83 and about a 20 percent chance of living to at least age 92. If this worker is female, she has about a 50 percent chance of living to at least age 87 and about a 20 percent chance of living to at least age 94. Since all women and many married men will need to plan using the woman’s life expectancy, and since I like to be conservative in my assumptions, I’ll use the longest of these life expectancies for my example: a female worker named Kim who is now 25 years old and who lives to age 94, or a time horizon of 69 years.

In the early stages of her career, Kim has no plans to draw from her Thrift Savings Plan account as it accumulates. Her primary investment objective is to grow the account balance as much as possible until the time she will need the money at age 55. The ups and downs of the stock and bond markets are of little concern to her at this point, and she should choose to invest the majority of her money in the TSP funds with the greatest growth potential: the C, S and I funds. The TSP’s L Fund allocation schemes can be used as a guide for allocating her account.

Some out there might ask: “Why not just allocate the entire account to the fund with the highest expected rate of return, like the S Fund?” The problem with this idea is that it ignores the fact that at some point, Kim will want to either begin taking withdrawals from her account or shift her investment strategy to something more conservative in anticipation of taking withdrawals. In generating the highest expected rate of return among the TSP’s five funds, the S Fund also produces a high level of price variation. Withdrawing or shifting strategies when the S Fund, and her entire account in this case, is on a severe downswing, fails to achieve her goal of maximizing growth. She is more likely to achieve her goal if she

uses a combination of funds that is designed to reduce risk more than it reduces expected return. Still, in the early years of her career, Kim enjoys a wide margin for error in her investment decisions. The negative effects of a bear market early in the game will likely be completely erased by growth over time.

As Kim approaches and enters retirement, however, the margin for investment error decreases rapidly. With the need to withdraw money comes a major shift in her investment objective. Rather than maximizing growth, Kim now needs to maximize the probability that her withdrawal needs will be met. That benign bear market in her 20s could now ruin her plans if it occurs during a period when withdrawals must be taken to meet income needs. Remember that a $5,000 withdrawal is 5 percent of a $100,000 TSP account — probably a sustainable annual withdrawal rate at age 55. But that same $5,000 is 10 percent of the balance if the account has collapsed to $50,000 during a bear market — an annual withdrawal rate that is not likely to be sustainable over long periods of time.

To support her new investment objective — a reliable and sufficient income stream — Kim will have to change her strategy. This means paying more attention to the balance between the return she expects and the risk, or volatility, she takes to get it. If she were age 52 today and in good health, she would have a 20 percent chance of living to at least age 94, or 42 more years. While she might want to rein in the volatile a little by making sure that her portfolio is fully and efficiently diversified and keeping investment expenses under control, it would probably be a mistake to let risk rule absolutely and to adopt a strategy dominated by fixed income and cash investments. In fact, if a steady and reliable income stream over more than 10 years is your goal, you will probably be better served by sticking with an investment strategy that is more than 50 percent stocks.

There is no rule of thumb for investment strategy that fits every, or even most, individual situations. There is a general approach to matching investment strategy to the objectives of early, middle and late stage investors, however:

- When withdrawals are at least 15 years in the future, expected rate of return is the dominant factor and an investor can be aggressive, maybe even a little speculative, although not reckless.
- From the time that withdrawals are about 10 years out to the time that life expectancy falls to 15 years, carefully balancing expected return with risk is most important and the need for rigorous analysis and planning the greatest.
- When life expectancies, or the planning horizon, shrink to less than 15 years, risk management should take over as the key factor and your strategy should more appropriately be dominated by fixed income and cash securities.

*Written by Mike Miles
For the Federal Times
Publication April 9, 2007*