People have practiced portfolio diversification since before biblical times. As an example, here’s a passage from an ancient Hebrew text from around 1200 B.C.: “Let every man divide his money into three parts, and invest a third in land, one third in business and a third let him keep by him in reserve.” A modern investor might interpret the first part as investments in real estate and stocks. The third part is not quite as clear. Asset allocation expert Roger Gibson defines “reserves” as U.S. government bonds, whereas investment manager and author Bill Bernstein believes that during those ancient Jewish times it would have referred to “silver.” Regardless, the concept is unambiguous: spread your risks, and resist the temptation to put all your proverbial eggs in one basket.
Conceptually, asset allocation is quite simple. Identify a set of diverse investments that don’t always move in lock-step. Set a risk level that you can handle, and which is also prudent based on how many years are left until you retire. Evaluate the possible asset mixes whose risk meets your tolerance. Compute the theoretical returns for each of these portfolio combinations. Select the portfolio combination with the optimal risk and return.
Simple though it may be in theory, asset allocation is challenging to implement in practice. For instance, what risk level exactly are you comfortable with? How do you even define risk? And even for those few investors who grok the mathematical calculations, a theoretical understanding of potential risks is not at all the same as experiencing the real deal, as any “old timer” investor who’s suffered through a few bear markets will point out. Your personal survival instincts are your worst enemy, and nag you at the worst possible moment.
Asset allocation for TSP participants boils down to choosing among the 5 basic TSP funds, or allocating your full account balance to one of the pre-set asset mixes, the Lifecycle or “L” Funds. The latter option is convenient for investors who don’t care about the specifics, but as with many choices in life, the easy choice is not always the best.
The five TSP funds cover 2 asset classes: fixed income and stocks. The most conservative is the G Fund which holds a fixed income security that is guaranteed not to lose its principal. Its probable gains are therefore also the lowest. The other bond choice is the F Fund, which tracks an index of investment grade corporate and government agency bonds. These two bond funds are invested in U.S. securities only. The other three funds are stock funds. The C Fund is invested in an index consisting of large domestic stocks. The S Fund is held in a broad index consisting of small domestic stocks. And the I Fund invests in foreign equities in so-called “developed” markets. Mix and match from these funds and you’ll have a decent equity and fixed income investment portfolio.
It is surprising how many TSP investors don’t even get this far. Casual conversations among coworkers reveal that far too many don’t even have a well-diversified portfolio of equities and fixed income, but rather plow almost all of their money in one concentrated asset class or the other. Certain Feds allocate too much to the risky assets (all stocks), while others over-allocate to the conservative (mostly bonds).
A sophisticated investor shouldn’t stop there. As you get closer to retirement, you may very well open more investment accounts aside from your Thrift Savings Plan. After you’ve maxed out the annual deduction, if you still have more savings, you can contribute these to a regular investment account. Another common scenario may be that you have a working spouse who is not a Federal employee. Investors who encounter this situation frequently ask: what do I invest the additional money in? Now that you have more options than only the five TSP funds, your situation gets a little more difficult.
With the basic domestic stock/bond portfolio in place, consider allocating a moderate percentage of your retirement funds to emerging markets equities, for additional diversification. One good additional index fund will be enough. A good choice would be Vanguard MSCI Emerging Markets ETF.
And don’t forget about real estate, which also has historically proven to have low correlation to other asset classes. The simplest addition you can make here is to add one good Real Estate Investment Trust (REIT), such as the Vanguard REIT Fund (VNQ).
Next up is alternative investments such as commodities. Here’s an asset class that’s often passed over. The simplest approach to investing in commodities is by owning an exchange traded fund (ETF) that invests in them. These funds trade very much like stock shares, and you can place an order to buy and sell them through any broker. For most TSP investors the most suitable commodity ETF is one that follows a broad index. One example of a commodity index fund is the PowerShares DB Commodity Index Tracking ETF (DBC), but others exist which follow different indexes. For investors with larger portfolios, moderate allocation to more individual commodities could make sense. For instance, to benefit from rising gold prices, you can invest in the SPDR Gold Fund (GLD). Or to track the price of crude oil, try the Teucrium WTI Crude Oil Fund (CRUD).
Don’t forget to practice diversification and don’t put excessive amounts of your retirement into any one “basket”.
Baby boomers in the Federal workforce often invest in TSP funds in addition to other investment accounts. Learn how to allocate your retirement portfolio to the many available investment options.