It is important to consider a number of factors in deciding how to invest your Thrift Savings Plan assets: your investment time horizon, the amount and timing of contributions and withdrawals, your income tax situation, and your expectations about future investment performance among the investment funds. It is the last of these factors — investment performance expectations — that seems to give investors the most trouble.
Trying to make investment decisions without knowing what to expect from your investments is foolish. Amazingly, though, the majority of investors I encounter do just that — make important investment decisions without having even a basic understanding of how the investments they are using are likely to behave.
Would you walk into a casino and bet your life savings on a game without understanding how the game works — without knowing the odds? Well, in investing, people do it every day. They see a sign that says “Million Dollar Payout” and they put their money in the slot and pull the handle. Never mind that the odds of losing everything are 10 million-to-1. This might be fun if the worst result were the loss of a few dollars. But the result could be disastrous if your retirement lifestyle is at stake.
Two fundamental values — risk and return — are essential to investment strategy development. The statistics that measure those values tell you much of what you need to know about investment performance and help you compare one investment choice with another, particularly within the same category of investment.
Risk is the chance that your investment will produce results, including returns, that are different from what you expect. One way to estimate expected risk is to use standard deviation, which measures how far an investment’s historical annual returns have varied from its average return. Standard deviation, which will be specified as a numeric value, captures about one-third of the annual returns above or below the average return over a given time. For example, suppose the standard deviation of a particular investment over 60 years is determined to be 14 percent, and the investment’s average return over that same period is 10 percent per year. Then in about one-third of those years, the annual return was between 14 percent and 24 percent and another one-third of the annual returns were between 14 percent and minus 4 percent.
Expected return is the average rate of return, usually expressed as an annual amount, expected from an investment. For a fully guaranteed investment, like a certificate of deposit, this value will be at or close to the guaranteed rate of return. For a risky investment, like a stock mutual fund, it should be based on conservative estimates and the long-term historical average rate of return for that investment. By long term, I mean 60 years or more, if available.
With these two characteristics known or estimated, an investor is in a position to predict future rates of return and the extent to which these returns are likely to vary from year to year for a particular investment. Fortunately, professionals have done the work for you, and each of the Thrift Savings Plan’s five funds was selected based on these two measures. In each of the five asset classes represented — domestic large company stock, domestic small company stock, foreign stock, domestic fixed income and cash equivalents — the TSP funds deliver relatively high expected returns and relatively low risk, compared with the alternatives. It would be difficult or impossible to find a large cap stock investment, for example, that would deliver a higher expected rate of return for the same level of risk as the C Fund. Or, vice versa, it would be tough to find an investment that offered less risk with the same expected rate of return.
Written by Mike Miles
For the Federal Times
Publication June 26, 2005