In my Sept. 27 column, I discussed intramarket diversification and explained how it can help to reduce a certain kind of risk in your Thrift Savings Plan account without reducing the rate of return you should expect from your investment. In this column, I will discuss intermarket diversification and its benefits.

Like intramarket diversification – owning multiple securities within a given market – intermarket diversification is an important investment management tool that should be used to its full potential in every retirement investment portfolio.

Intermarket diversification is the process of dividing your investment portfolio among a variety of markets with different behavioral characteristics. Allocating your investment among stocks, bonds and cash is an example of intermarket diversification, as is dividing your stock holdings among the stocks of various industries, countries and company sizes. Like intramarket diversification, the idea is to avoid having all of your eggs in one, or too few, baskets.

The objective of intermarket diversification is to combine two or more assets in a way that reduces risk, or volatility, faster than it reduces the expected rate of return. Doing this properly improves the risk-adjusted expected rate of return (RAEROR) and should be one of your foremost goals as a pension fund manager.

To illustrate the concept at work, consider two hypothetical investment assets: A and B. Both assets have an expected rate of return of 10 percent. Their standard deviation, which is a measure of volatility, is estimated to be 20 percent. This combination of standard deviation and expected rate of return means that both assets are relatively risky and that losing years are fairly common. On its own, neither asset is a very attractive late-stage retirement investment choice, since the high risk of loss will significantly reduce the regular withdrawals that can safely be taken from the account. Suppose, also, that the returns from A and B are negatively correlated – that is, their prices move exactly opposite one another. When A’s price moves up 1 percent, B’s price moves down the same amount.

Now consider what will happen if you split your investment equally between A and B. Since each asset has an expected rate of return of 10 percent, a portfolio composed of 50 percent A and 50 percent B will also have an expected rate of return of 10 percent. But, when the price of A falls, the price of B will rise by the same amount, proportionately. This means that the portfolio will have no volatility – no risk of loss. Diversifying your investment between A and B has produced a portfolio with a much higher RAEROR than investing in either asset, alone.

The key to effective intermarket diversification isn’t in owning different assets or securities, it is in owning various uncorrelated assets – assets that don’t tend to behave the same way at the same time. It is not unusual for investors, or their advisers, to build portfolios composed of lots of highly correlated securities, which doesn’t really provide effective intermarket diversification. In practice, it isn’t possible to find perfectly negatively correlated assets like A and B, but you can find assets that are not perfectly positively correlated. When it comes to diversification, less correlation between assets is better than more and some diversification is better than none.

Diversification is a tool – a means to an end. When it comes to retirement investing, that end is the certainty of cash flows – confidence that the cash you need will be there when you need it for as long as you live. If your retirement plan will require that your investments will earn 8 percent per year, on average, to support those cash flows, then your job as a pension fund manager is to maximize the probability that the portfolio you’re managing will produce that rate of return. Diversification is the most reliable way to do this.

While the TSP does not automate intermarket diversification the way it does the intramarket variety, it does offer an excellent set of resources to accomplish the job. The TSP’s five basic funds are all you need to produce a portfolio that lies along the “efficient frontier” – the set of investment portfolios that offer the maximum expected return for the risk they impose. You can also use the L Funds to mix these five funds together in ways that accomplish this for you. Whichever route you choose, remember that, when in doubt, invest in all five TSP funds, all the time.

*Written by Mike Miles
For the Federal Times
Publication October 11, 2010*