Warren Buffet is often quoted as saying investors should try “to be greedy when others are fearful” and “fearful when others are greedy.” This is a simple foundation to investment management that seems to elude most amateur, and some professional, investors.

A wide range of evidence – including Thrift Savings Plan funds flows, savings contribution rates and the questions I receive from readers and clients – proves that investors too often are most fearful when investment risk is relatively low and most confident when investment risk is peaking.

If you feel like abandoning some or all of your position in the C Fund, for example, ask yourself why. Is it because the C Fund has lost money over the past week, month or year? Now consider when the risk of loss in an investment is higher: The higher the price rises, the more room it has to fall and the greater the risk of loss.

In 2007, when the stock market reached its all-time high, I don’t remember hearing any talk from fearful investors about selling. The talk I heard most was about moving more money into the C, S and I funds and other stock investments. Investor confidence was high, as it usually is, when the markets were high. This confidence was based on simple analysis: Take your account’s value, assume that it will earn some fairly conservative rate of return every year for the rest of your life and use that rate of return as your assumed withdrawal rate. If that amount meets your needs, you’re confident that you can retire in comfort.

A year later, the same analysis of the same TSP account produced very different results. The account’s value was maybe half of what it had been at its peak in 2007, and the numbers didn’t look good. The problem was compounded if the market’s collapse also inspired you to use a lower expected rate of return in your calculations. All of a sudden, what was a comfortable retirement plan looked like a disaster. One day, you’re ready to retire and the next you wonder if you’ll ever make it.

This is not planning or investment management. This is reacting to what has just happened and assuming that the current trend will continue. This kind of thinking leads to irrational behavior. In 2007, when stocks were nearing their all-time highs, you should have been thinking about moving money out of the C, S and I funds and into the F and G funds. You should have been fearful that a fall from that height could be fatal. You should have recognized that your account’s value was inflated and that your expectations for future returns might have to be lowered.

Now, when fear seems to dominate, is the time to be more aggressive. Of course, stock prices could go lower, but they’ve already shed a huge amount of risk. You should be much less fearful of investing in stocks today than you were during most of the past 10 years. Future rates of return from stocks are also more likely to be higher today than at most times during the past 10 years.

More conservative when risk is high, more aggressive when risk is low – that’s the smart approach.

Of course, you can shift your investment strategy only as much as your plan allows. Most retirement plans that I’ve worked with will not work safely if the allocation to bonds and cash is too high. By the same token, most plans will be unnecessarily volatile if invested too heavily in stocks. You can shift your allocation in response to changing market conditions, but most investors will be best served by using all five basic TSP funds at all times.

Right now, prudent investors will be more heavily invested in stocks than they were in 2007 or 2008. As markets continue to recover their lost value over time, prudent investors will shift their asset allocation more toward bonds and cash. This not in response to one of the many predictions about which way the markets are headed, but in accordance with your financial plan’s need for future returns and the risk that goes with them.

When your account’s value is high, you can plan to make do with less return – and less risk. When it’s low, you’ll need the additional returns and risk to make the same plan work.

Written by Mike Miles
For the Federal Times
Publication August 24, 2009