I sometimes hear Thrift Savings Plan investors define their investment goal as: “I want to make a lot of money without ever losing any money.” This demonstrates a fundamental misunderstanding of investing — how it works and what it can do. In particular, this kind of thinking ignores the reality that investment risk and return are intimately connected. You can’t enjoy the latter unless you’re willing to endure the former.
Failing to recognize this truth will lead you to make poor investment decisions. Poor investment decisions usually lead to poor investment results, and poor investment results often lead to poor, or at least poorer, investors, in the end. So, successful investing relies on good decision-making, and good decision-making relies on a good understanding of the factors that affect the outcomes.
Two key factors in this equation are investment risk and return, and understanding them and how they work is essential to investment success.
Investment risk is the possibility that an investment will produce an unexpected return in the future. For our purposes, investment risk affects both the average rate of return over time and the sequence of periodic returns that produce that average. When you are contributing to or withdrawing from your investment portfolio, these factors affect the value of your portfolio.
While you may assume that earning 9 percent per year, on average, over 20 years, is preferable to earning 8 percent, the fact is that the 8 percent average may actually leave you with more money, depending upon how the sequence of yearly returns aligned with your sequence of yearly contributions or withdrawals. In other words, it is not just the long-term average rate of return that matters, but also the sequence of yearly returns that produces that average. Assuming that the investment strategy with the highest expected rate of return is the best choice can be dangerous.
Investment return, on the other hand, is the change in value that an investment produces in exchange for taking risk. Investment return consists of yield and price appreciation or depreciation. Yield is the cash income received from the investment while it is held — interest or dividend payments.
Appreciation and depreciation are produced when an investment is purchased for a price and then later sold for a different price.
Investment risk and expected return are inexorably connected. A change in one always effects a change in the other. Risk is a means to an end and should not be indulged arbitrarily. You should always expect to be compensated for taking risk. Risk and expected return can be identified, quantified and managed to your advantage, and doing so is the point of investment management.
When it comes to managing your TSP account, your primary objective should be to realize the expected return in each and every period — I think a year is a reasonable measurement period — during the life of your account. Predictability is the most valuable commodity when you’re investing for maximum retirement income.
As an investment manager, your job is to manage your TSP account in a way that seeks to balance risk and return so that for the risk you’re taking, you can reasonably expect the maximum amount of return each period. From another perspective, you should manage your account to achieve a target return with as little risk as possible. This is maximizing predictability.
One way to do this is to use one of the TSP’s L Funds. While doing so doesn’t guarantee that your investment objectives will be met, or that your account will safely support your spending goals in retirement, it does ensure that your TSP investment will be risk-efficient. All of the L Fund asset allocation schemes have been carefully formulated to deliver the maximum expected return for the level of risk they assume.
It’s no coincidence that the L Funds employ all five basic TSP funds all of the time. That’s because this is one of the keys to achieving that optimal balance of risk and return. Using them, or even just the allocation models they provide, and sticking with all five of the basic funds all the time, ensures that you are never taking risk for which you don’t expect to be paid.