Watching the news about the Gulf of Mexico oil spill, I am struck by the similarities between drilling for oil and trying to extract wealth from an investment portfolio. After wondering — and worrying — about the impact of the spill on life and livelihood, my question was: How could this well have been drilled without a reliable plan to stop the flow of oil in the event of a problem?”
I realized that most investors — Thrift Savings Plan investors included — make the same mistake with their portfolios every day: They take risks that they don’t understand, or choose to ignore, and can’t afford.
Like drilling for oil, managing your investment portfolio for retirement income is an exercise in risk management. Failing to plan for, and manage, risk properly can result in disaster.
Some of the oil-spill lessons to be applied to management of your retirement portfolio:
• Understand your capabilities. One way to do this is to rank yourself against an imaginary perfect investment manager using attributes such as “ethical,” “reliable,” “capable,” “committed,” “skilled” and “experienced.” We’ll assume that since you’re considering managing your own money, you’re ethical, but what about skilled and experienced? Incompetent operators shouldn’t be allowed to drill oil wells because the risk is so great. Doesn’t managing your savings deserve the same respect?
• Accept your limitations. Not great in math and statistical analysis? Don’t have the time to spend managing your portfolio properly? Then admit it. If you’re not an expert in “drilling,” you should probably find someone you can trust to help you until you can become one. Learning on the job at your own expense, or the expense of those you care about, can be catastrophic. Successful investment management is more about avoiding critical mistakes than about striking a gusher.
• Take a long-term view — your lifetime, at least. Your investment strategy should be designed to support your long-term goals, and the tactics you employ should be consistent with this strategy. Does it make sense to risk everything in pursuit of a relatively unimportant goal? Is looking for short-term gains that you don’t need, or avoiding short-term losses that won’t really hurt you, worth risking your ability to pay your bills 10 or 20 years from now? Look at the mess that one failure on one oil well produced. I would argue that the risk taken in drilling that one well was not worth the potential gain from drilling it — particularly when the risk could have been avoided without sacrificing the benefit.
• Minimize unnecessary risk. Of course, we need fuel for energy. But are we choosing the lowest-risk ways to get it? While it’s important to obtain enough investment return to support your goals, do everything in your power to realize the needed returns with the minimum risk. Properly diversifying your portfolio is the secret to minimizing the risk to generate the returns you need. Notice that minimizing risk is not the same as avoiding all risk. Every investment involves risk. Rather than fear risk, manage it to your advantage.
• Don’t accept unacceptable risk. If a low-probability event will prove devastating, then find a way to reduce the potential damage to an acceptable level or find a way to avoid the risk, if possible. If a bad year in the markets will devastate your retirement plan, that’s an unacceptable risk. Likewise, if failing to realize the needed returns from your portfolio over time will devastate your retirement plan, then this is also an unacceptable risk. Bad years in the investment markets can, and will, happen. Insufficient rates of return from overly conservative strategies can, and will, happen. Either, if it results in a failure to achieve your key goals, is an unacceptable outcome and your investment strategy should seek to eliminate this possibility.
There are a lot of things you might worry about in the world today. But, if you do things right, your TSP account doesn’t have to be.