Q: How does one go about determining the most advantageous proportions of all five funds to achieve one’s expected level of return? And after knowing that secret, how does one know when is the right time to to adjust these proportions?
A: I can tell you how I do it in my practice. I know of no better way to do it: We use long-term historical data and some practical knowledge to make assumptions about the expected rate of return, standard deviation of those returns and correlation coefficients for each of the asset types underlying the asset types you’ll be using, or might be using. Then we use a process called Mean-Variance Optimization to find the combinations of those assets that provide the highest risk-adjusted returns at various points along the range of available risk levels. We then use Monte Carlo simulation to test the various efficient portfolios we’ve created against your set of goals and constraints to find the one that safely supports these goals with a minimum of risk. Once the asset allocation is selected, we rebalance the portfolio accordingly, using a proprietary set of investment securities or the TSP funds, if available. This process is repeated every six months, from scratch. It all starts with the performance estimates, which are critical to the results and deserve a great deal of care and attantion in formulation.
