Portfolio diversification is a concept that every TSP investor should understand and use to their advantage. It’s also a concept that few seem to properly employ.
Over the past 15 years, there have been calls from participants to add all manner of specialized investment funds to the Thrift Savings Plan – Internet, real estate, energy, gold, health care or any other market that has been hot — in the name of diversification. Ironically, these calls for more ability to diversify wouldn’t really help to improve diversification. Instead, adding these kinds of funds will, more than anything, allow participants to concentrate their portfolios in riskier assets and degrade the expected performance characteristics of their portfolios. To me, these calls for specialized funds, or even access to individual stocks and managed mutual funds, in the name of improved diversification, are evidence of a clear lack of understanding about what diversification is, how it works, and what it is intended to accomplish.
Generic diversification – that is, arbitrarily dividing your portfolio among multiple securities – is not, in itself, particularly valuable. Done correctly, however, it will allow you to manage your TSP account in a way that will reliably produce the maximum income possible over your lifetime. This is because volatility in your account’s value is the enemy of predictable income, and diversification is the best way to manage volatility. More specifically, it is negative volatility, or “periodic underperformance,” that is the problem, and the risk that diversification is most effective at reducing.
Every investor should be using the two basic types of diversification, in their portfolio, unless their portfolio is entirely in cash:
Intra-market, or within-market, diversification. This is owning more than one security of a given type at a time. It reduces the risk associated with an individual security without reducing the expected rate of return for that type of security. If you own one large company stock, for example, you are bearing all of the risk that this company might fail to deliver the expected results. Divide the same position between two large company stocks and you reduce that risk by half. Divide it among three and you reduce it by two-thirds. Own the C Fund, instead, and you reduce the risk to 1/500th of what it would be with only one stock. By owning fully or widely diversified index funds, you can minimize the security-specific risk you face without significantly reducing the expected rate of return for an asset type or your portfolio as a whole. The TSP’s funds, as market index funds, are inherently well-diversified within the markets each fund represents, so they are foolproof in this aspect of portfolio construction.
Inter-market, or between-market, diversification. Like its intra-market cousin, it is a means to reduce portfolio risk. The idea is to combine securities from different markets – like stocks and bonds, for example – in ways that tend to reduce portfolio risk more than they reduce the expected rate of return. Stocks tend to have a higher expected rate of return than bonds, but their prices tend to move in opposite directions at the same time. Combining these two assets in a single portfolio averages their expected rates of return to give the portfolio an expected rate of return between that for each of them on their own. But, since when one is up, the other is often down, and vice versa, mixing them tends to smooth out the bumps that come from market fluctuations. In many cases, a less volatile portfolio with a lower rate of return will actually support a higher distribution rate in retirement than a more volatile, but higher-returning, alternative.
Fortunately, the TSP, through its five basic funds, offers you exposure to well-diversified markets in stocks, bonds and cash, which are the only tools you need to construct a well-diversified and risk-efficient portfolio.
Carving out and concentrating your investment in narrow slices of the larger investment universe, like the “hot market” examples I mentioned, doesn’t increase diversification beyond what is already available in the TSP. Instead, it reduces diversification and increases the risk that your portfolio will underperform expectation. This is entirely counterproductive to maximizing a reliable stream of retirement income from your account. Effective diversification is essential to maximizing the retirement income that your TSP account will support. Therefore, it is essential that you understand what effective diversification is, how it works, and how to use it to your advantage.