Every federal employee has heard the saying, “Don’t put all your eggs in one basket.” If you understand this concept, you understand one of the most fundamental principles of sound investing, diversification.
Given the recent stock market turbulence, I thought it would be good to review this essential principle. So, this week we’re going to review how diversification can reduce the risk in your TSP.
What Is Diversification?
Diversification is an investment strategy through which you spread your portfolio across different asset classes (stocks, bonds, and cash) to reduce the amount of exposure to any one asset category.
Your mix of these assets is called your asset allocation. The TSP makes establishing your asset allocation easy by limiting your selection to five funds while still allowing you to diversify over the three most common asset classes: stocks (C, S, I), bonds (F), and cash (G).
Why It’s Important
Diversification is one of the only ways to achieve “a free lunch” in investing because it allows you to reduce your risk while increasing your expected return. In other words, diversification helps you reduce the overall effects of market swings while allowing you to potentially improve the performance of your TSP.
This strategy works because some assets will perform well while others do poorly, and often, the reverse becomes true, with the former stragglers becoming the new winners. Historically, stocks, bonds, and cash have not moved up and down at the same time. Typically, the conditions that cause one to do well often cause the other to have average or poor performance.
Hence, by not putting all your eggs in one basket, you’ll minimize the chances of any one fund hurting your account while potentially increasing the average return of your TSP.
Your Risk Profile Should Drive Your TSP Allocation
Determining which mix of funds to hold in your TSP is very personal. The asset allocation that works best for you at any point in your life will depend on your time horizon, risk tolerance, risk capacity, and required rate of return. These four components make up your risk profile.
One of the keys to successful investing is learning to align your asset allocation with your risk profile. To learn more about defining your risk profile, read this article.
Selecting Your TSP Funds
Once your risk profile has been determined, you’re ready to select the asset allocation for your TSP. When choosing the combination of funds, the general rule is that the more willing and able you are to take risk, the more you can allocate to stocks.
This is because, historically, stocks have had the greatest risk and highest returns among the three major asset categories. For instance, if your risk profile indicates that you’re willing and able to take high levels of risk, you might decide on an 80/20 allocation, meaning 80 percent stocks and 20 percent bonds.
On the other hand, if you’re risk-averse, an asset allocation of 70/15/15, meaning 70 percent stocks, 15 percent bonds, and 15 percent cash, might be more appropriate. Although bonds and cash have lower average returns, they add stability and reduce the risk of large swings in your TSP account value. Having a stable account value will be essential once you start withdrawing from your TSP in retirement.
To achieve diversification, however, you’ll want to diversify your TSP by asset categories and within asset categories.
For example, if your allocation is 80/20, you wouldn’t just stuff 80 percent of your portfolio in the C Fund since this Fund only tracks large U.S. companies, and in a market crash, all these companies would behave similarly.
Instead, you would decide how much of your 80 percent stock allocation you wanted in large domestic companies (C Fund), in small domestic companies (S Fund), and how much you wanted in foreign companies (I Fund).
For instance, a diversified TSP might look something like – 20 percent in the F Fund, 40 percent in the C Fund, 15 percent in the S Fund, and 25 percent in the I Fund.
For a detailed review of each Fund, read this article.
Monitor And Adjust
While your asset allocation shouldn’t frequently change, your risk profile will generally necessitate a change in allocation as you approach retirement. For example, most federal employees five or fewer years from retirement should start to allocate at least a portion of their TSP to the F and G Funds.
Yet, you shouldn’t change your asset allocation based on the relative performance of asset categories. For example, increasing the proportion of the C Fund in your TSP when the stock market is performing well. Remember, your risk profile should drive your asset allocation; those that forget this usually run into trouble during an unexpected market crash.
Additionally, since each Fund will grow at a different rate, your TSP allocation will eventually move out of alignment. Thus, you’ll need to periodically bring your account back to your original asset allocation, also known as rebalancing.
Utilizing the five TSP funds to spread your portfolio across the three major asset classes will reduce your risk and increase the long-term performance of your account. And while no strategy can guarantee great investment performance, diversification positions your TSP to benefit from broader market conditions.
When selecting how much of your account to dedicate to each Fund, ensure that your time horizon, risk tolerance, risk capacity, and required rate of return drive the decision. Additionally, you’ll need to monitor the appropriateness of your allocation periodically or whenever there is a change in your risk profile.
While a diversified portfolio is the foundation of any wise investment strategy, building it can seem daunting. This is why I recommend consulting a fee-only Certified Financial Planner™ if you don’t feel confident creating your investment plan.
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