While I don’t follow everything that comes out of Donald Trump’s mouth and through the media, something he said during the first presidential debate did catch my attention. In fact, it’s the only thing from that debate that I thought much about after it was over. He said that we were in an asset bubble that would pop when the federal reserve allows interest rates to rise. He claimed that the fed’s control of interest rates, and the bubble it has produced, are politically motivated. I read his comments and tone to imply that, if he is elected, he will end that control and allow the bubble to break.
What he was explaining is the asset values and interest rates tend to move in opposite directions. This is important for TSP investors to understand because changes in the prevailing interest rates will affect the value of their C, S, I and F Fund shares. This is because the price an intelligent investor will pay for an asset is calculated using a “discount rate”. This is the factor used to figure out what you should pay for future cash flow, today. Larger discount factors mean lower present values, and discount factors are connected to interest rates. So, all other factors being equal, an investor will pay less for a share of stock or a bond when interest rates are expected to be high, than when they are expected to be low.
Immediately following the debate, the stock and bond markets gained value. That’s probably because the markets are not expecting a Trump victory – yet. If they do begin to expect Trump to win, I expect to see the markets lose value based on the perception of an increased likelihood of higher interest rates, if for no other reason. More specifically, if Trump becomes the favorite to win in November, you should expect to see the C, S, I and F Funds lose some value, if only based on his comments about interest rates.
The only TSP fund that is immune to this effect is the G Fund, which guarantees that its share price will not fall, and which will deliver better returns as interest rates rise. The only way to protect yourself against the negative effects of higher interest rates is avoid the C, S, I and F Funds, entirely. But, assuming that a 100 percent G Fund allocation will not provide the returns you’ll need over the long run to support your withdrawal needs, this tactic subjects you to another kind of risk; the risk that your account’s value will be less than expected in the future, and less than you’ll need to support your financial goals. Rather than trying to win an all-or-nothing bet on market timing, it’s better to hedge your bets by balancing the various risks you face. Instead of avoiding necessary risk – the risk you need to take to achieve your long term financial goals – it’s better limit your risk exposure to only what is needed to support those goals. Any “extra” money should go into the G Fund, where it’s safe.
This approach will mean that your account will be divided between the risky stock and bond funds, and the risk-free G Fund, at all times. Since higher interest rates will hurt both the stock and bond funds, at the same time, the G Fund is the only fund that will provide a hedge against the risk of higher interest rates. And, while it’s scary to lose money to a market down-turn, the current value of your account does not determine whether you will succeed or fail in funding your lifetime of financial goals. That will be determined by where you are today and what happens between now and the time when your need for money ends. When asset values are relatively low, the prospects for their future returns improve, and vice-versa. A good financial plan, and the investment strategy that supports it, takes this reality into account and allows for it. It is designed to succeed in spite of the inevitable crashes in value that will occur from time to time, rather than to pretend that they can be consistently avoided. It is smart to take steps to minimize the risk of loss, but only to the extent that this effort doesn’t compromise the opportunity to earn the returns you’ll need in the long run.
Written by Mike Miles
For the Federal Times
Publication October 2016