Hedging is an investment concept that is either too unfamiliar or seems too exotic to be seriously considered by most individual investors. But, as a Thrift Savings Plan investor who is relying on your savings — and your skill at managing those savings — to provide you with an acceptable lifestyle in retirement, you should recognize hedging as an essential element of a sound investment strategy.
Hedging is nothing more than finding ways to reduce the investment risk you face to an acceptable level. Fortunately, the TSP provides you with everything you need to implement an effective strategy to hedge against the various types of investment risk that can derail your retirement plans.
Consider the main sources of investment risk that could cause your retirement plan to fail:
Return risk. This is the risk that your TSP assets will fail to produce the return — growth in value — that is required to meet your expected needs. If you have financial goals that depend on your savings for funding, you’ll need those savings to earn some minimum rate of return over time to support those goals.
The risk here comes from being too conservative — investing in assets that won’t produce the rate of return you need. If return risk was the only risk you considered, choosing an investment strategy would be easy. You’d simply choose the option with the highest expected rate of return. In the TSP, that choice would be the S Fund, which invests in the stock of small and medium-sized domestic companies. But, of course, it’s not that easy.
Volatility risk. This is the risk that your account will produce returns over any given period that are different from those you expect. There is an inviolable rule in investing: If you want greater expected return from your investments, you should expect to accept greater risk that you won’t realize that return.
If you want an expected return of 12 percent, you should expect to accept a wider range of actual results than if you only need 4 percent. So, the problem with investing your entire TSP account in the S Fund in order to earn that 12 percent return is that there is a high probability that the return it produces will be different — in particular, less — than 12 percent.
Taking withdrawals from your account for retirement living when it has dropped 20 percent below its expected value can handicap the account’s ability to produce expected income from that point forward. Volatility is a larger threat to your retirement plan once you begin to withdraw from your account than when you are saving.
Inflation risk. This is the risk that your spending needs will grow faster than your savings’ ability to produce spendable income. All Federal Employees Retirement System annuitants face inflation risk in that their annuity income is guaranteed to lose its purchasing power over time. The FERS formula for cost-of-living adjustments builds this into the program.
An investor who wants to avoid volatility by investing heavily in fixed income assets like cash, certificates of deposit or bonds at the expense of stocks trades one kind of risk for another. He may enjoy lower volatility, but is accepting greater inflation risk. While less obvious in the short run, inflation risk is just as threatening to a retirement plan as return risk and volatility risk.
So hedge your bets. You want to own stocks — the C, S and I Funds — for their return potential and inflation protection. The problem is that their volatility is high and a bear market can do irreparable damage to your account’s ability to support a future income stream.
You want to own cash through the G Fund and bonds through the F Fund for their low volatility, but they might not be capable of generating the return that you need. Some think they can time the markets to hedge against risk, but, in fact, this only adds another layer of risk — the risk of being wrong.
The safest solution is to hedge against all of the risks you face, all of the time, by owning all five of the TSP’s basic five funds all of the time. Each fund, to some extent, acts to hedge the risks produced by the others.