When setting up a portfolio the goal of the collection of assets is to perform a variety of functions and to collectively only take as much risk as would allow you to sleep at night. They call it asset allocation because you are going to “allocate” some money to companies that are growing rapidly, some to international companies because they aren’t experiencing the exact same economic environment as their American counterparts, some to bonds because they pay a regular income stream that can be taken or reinvested, and so on.
In the absence of other goals like the ones here you would still buy a variety of assets for their correlation features. Correlation means the extent to which the positions or companies or bonds would tend to move in the same direction of value over time. If they are highly correlated their use in your portfolio might be limited. If they tend to move opposite one another or entirely randomly compared to each other then there is more value.
One might allocate some to a cash position because although the return is non-existent it allows you to buy into assets at a moment’s notice without selling something else or to quickly access it for spending purposes without selling another asset. Rarely do suggested portfolios come with a large position in cash, though it might range from zero to perhaps 5%.
In the case of the TSP system, with its 5 investment choices, one has had to do the best they can, given that 3 out of the 5 choices are both volatile and relatively highly correlated asset classes, those being the C, S, and I funds. What helped in the past was the G fund was a fund comprised of a special security that replicates the interest earned on government bonds but that was also incapable of losing value, thus making it really better than investing directly in bonds. In years past this wasn’t really like a cash position because it had a health yield to it, and it wasn’t really like investing in bonds, like the F fund for example, because it didn’t have the volatility of the fixed income market. So when selecting an overall asset allocation there were options to take as much risk as desired and balance it out while earning a rate of interest.
That has changed though. Interest rates on fixed income have come way down over the past 30 years and the rate on the G fund has come down with it. Using data publicly available at www.tsp.gov the G fund has averaged an annualized rate of return since its inception in 1987 of 5.43% however, over the last 3 years it has averaged just 1.89%. On top of that the Washington Post recently reported there is a bill floating through congress to have the yield on the G fund more accurately reflect the risk free instrument that it is, which is to say make it earn zero, on average.
Keep in mind that all of this is occurring in a retirement account, so by definition the goal of the allocation the investor is choosing is typically to grow the money for later use. There are certainly instances where investors just want to know they are maintaining their principal, or they are temporarily holding funds in something like a cash position in retirement accounts, but predominately the goal is to grow assets or to produce income or both.
Holding any more than 5% allocated to an asset that does neither of those things, might not seem to make a whole lot of sense. If that’s true what will TSP as a system do? Continue on with offering long term investors only 4 viable choices to create an allocation, 3 of which lost over 36% of their value in a single year during 2008?
The answer of course is we will have to wait and see. It might be that the TSP system will continue to pay the 2% approximate yield it has recently despite the marketplace not supporting that as a realistic yield, or alternatively interest rates will turn around from their perpetual doldrums. As it happens, PSG and I will report on it.
If you would like to discuss this article or your personal allocation and goals feel free to reach out to me for a conversation.