Be cautious when stock prices rise


About a year ago, I encouraged readers to maintain some exposure to the Thrift Savings Plan’s stock funds — the C, S and I funds — in their accounts. At that time, the value of shares in these funds was at its lowest level in many years.

But since then, these funds have recovered a large chunk of their lost value by rising 50 percent or more from their lows. While still priced well below their peak 2007 levels, the funds have come a long way in a relatively short time.

By my measurement, the broad domestic equity markets have returned to levels that should inspire increased caution in prudent investors.

Unfortunately, too many TSP investors have the opposite reaction. As a fund rises in value, they tend to become more confident in its ability to produce future gains and more interested in buying the fund’s shares.

It is reasonable to allow a fund’s performance history to influence your investment decisions, as long as you read the signals properly. When a fund’s price has fallen, your buying interest should increase. When the price has risen, you should be more interested in selling shares than buying them. This is consistent with the “buy low, sell high” rationale for harvesting profits from risky investments.

There is another rationale, however, that might help to guide you to better decision-making. Think about the risk of loss in any given fund, and how this risk is related to changes in price. Investment loss risk rises as prices rise. The higher the price, the greater the possibility of future loss. And not only is the probability of a loss higher, but the magnitude of potential loss is also larger.

Think about real estate. Most people become more interested in buying a home, or less willing to sell it, as the price falls. As the price rises, their interests are reversed.

For some reason, behavior is often exactly the opposite when it comes to stocks. After prices have risen, investors want to buy, and after prices have fallen, they’re ready to sell. Not prudent.

As the prices of the TSP’s stock funds fell during 2008 and the first months of 2009, the prudent investor increased exposure to these funds. Then, as the prices of those funds have risen, the prudent investor’s exposure to them should fall. If prices rise further, then your account’s exposure to them should be reduced.

This is most easily accomplished through rebalancing your account to the proper asset allocation scheme. Such a scheme should generally include each of the five basic TSP funds in some amount.

For example, let’s say that you’ve decided to use the starting asset allocation for the TSP’s L 2020 fund in your account. This allocation, from the TSP Web site, is 34 percent in the C Fund; 27 percent in the G Fund; 19 percent in the I Fund; 12 percent in the S Fund; and 8 percent in the F Fund.

After a period when stocks have done well, the C, S and I fund balances in your account will rise above their target allocations. When this happens, necessarily, at least one of the two remaining funds will fall below their targets. Rebalancing to the targets will force you to sell some of the stock fund shares and buy some of the F or G fund shares.

The net effect is to reduce your exposure to stocks when their prices rise and increase your exposure to bonds when their prices lag.


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