Asset allocation is a term that should be familiar to anyone with a Thrift Savings Plan account. It’s everywhere in the investing world, but I have found that few investors understand what it is and what it is supposed to do. This is a serious problem since asset allocation is the main driver of investment performance. Study after study has shown that asset allocation overwhelms things like market timing and security selection in its impact on investment results. The TSP recognizes this and makes allocating your investment assets about as easy as it could be.
Before you can use asset allocation to your advantage, you’ll need to know what it is and how it works. For our purposes, asset allocation is the distribution of investment dollars among and between the three fundamental building blocks, or asset classes, of any retirement investment portfolio: stocks, bonds and cash. There are frequent arguments about what should qualify as an asset class, but these three get the job done nicely with the fewest number of moving parts possible. Adding additional classes, like real estate or commodities, just complicates the matter without adding anything to the results that can’t be obtained without them. Why use more when you get to do the job as well with less?
As I mentioned, the TSP has removed the confusion over this issue by offering you only access to these three asset classes — stocks in the form of the C, S and I Funds, bonds in the form of the F Fund, and cash in the form of the G Fund. I should point out that the TSP would serve its purpose nearly as well — and maybe better — by consolidating the three stock funds into one total market fund and simplifying the asset allocation equation to its limit.
The purpose of asset allocation in the first place is to manage risk. Each of the three building blocks hedges some of the risk in at least one of the others. The three rarely behave the same way and at the same time. When stocks fall, bonds tend to rise as investors move from riskier investments to safer havens. When bonds fall as interest rates rise, cash holds its value.
By spreading money around, you avoid the possibility of suffering the most severe loss in any market across your entire portfolio. The goal is to reduce the severity of the dips in your portfolio’s value, admittedly at the expense of not fully participating in the biggest gains. But when it comes to producing reliable retirement income, it’s predictability that is valuable, rather than upside potential. A portfolio that produces enough return, consistently, will generally support a higher withdrawal rate than one that produces high periodic returns alternating with large losses. It takes a 100-percent gain to recover a 50-percent loss!
Here are a few guidelines:
- Always hold the F Fund when you are holding any of the C, S or I Funds.
- Hold the minimum amount of C, S or I Funds necessary to support your return needs.
- Never hold a portfolio composed only of the C, S and I Funds, or the F Fund. Always hold stocks and bonds together.
- Always hold at least some G Fund in your portfolio.
- Unless you can afford to hold only the G Fund, or you are holding stocks and bonds in another account, you should always be holding all five of the TSP’s basic funds.
Asset allocation, done right, tends to smooth out the bumps, make your portfolio more predictable, and narrow down the range of possible outcomes for both your portfolio’s future value and the retirement standard of living that will safely support.
