In order for you to get to work today, or even better you’re already retired and going elsewhere, it is very likely that you drove to your destination. You had three vital components to get you there inside your car. You had the gas pedal, the brake and the steering wheel. Without all three of those, even if you were just missing one, you would not be able to complete that task to get you from point A to point B.
I am going to share an analogy that will show you the same concept in investing. Without these three components you can’t get from point A to point B (in this case retirement), so let’s take them one at a time.
The Gas Pedal
The gas pedal is great for going and going fast, but not so great for slowing down. On the TSP investment lineup, there are index funds (including the C, S, I and F funds inside TSP). They are great for going because they follow an index.
When things are good, like they have been for almost the past 9 years, it’s great because these funds are following the index closely. Unfortunately, we know that markets can also go down and so do those market indexes which means the C, S, I and F funds could go down as well.
The gas pedal is good for what it needs to do, but not the best for stopping the car, or for down markets.
You may be thinking that the F funds goes in a different direction than the C, S and I funds. It is a bond index, and don’t bonds do well in down stock markets?
This is generally true in declining interest rate environments. However, when we are in a rising interest rate environment, bond index funds such as the Barclays Aggregate bond index, or the F fund, can react adversely to rising interest environments. So unfortunately, what has worked for the past thirty-five years as investors move toward retirement and move more assets to bond indexes and bond funds, is likely not to workout favorably during the next several years.
The Steering Wheel
The next component is the steering wheel. As you were driving to work you were able to turn in different directions, maybe avoid a pothole, maybe avoid a potential accident or to just make a turn.
Separately Managed Accounts (SMA’s) work in the same way. They are actively traded and managed accounts on your behalf. SMA’s are managed by a professional asset management firm. Their job is to steer clear of potential hazards and to manage the portfolio to the best of their ability.
The last component is the brake. When we are driving we have to slow down and stop and need the brake for this to happen. We need a component that works differently than the gas pedal and the steering wheel.
In the investment world, this means looking at other investments that are not in the same alignment as stocks and bonds such as Alternative Investments or Fixed Indexed Annuities. We sometimes refer to this as fishing in a different pond.
You may be thinking, “what are alternative assets?” They are assets other than stocks, bonds or cash. Some common alternative investments are broken down in three categories.
The first is REAL ASSETS, commodity sectors including agriculture, energy, industrial metals, livestock and precious metals. Real estate assets can be land, buildings, infrastructure, real estate investment trusts (REITs), partnerships or mortgage‐backed securities.
The second is the SPECIAL category, private equity which encompasses venture capital, mezzanine capital, distressed investments, and leveraged buyouts.
The third is RISK-MANAGED strategies and includes a variety of hedge fund investment styles, such as long/short equity hedge funds and managed futures which seek to exploit differences in prices for similar securities. This differs from event-driven strategies which look to take advantage of price inefficiencies that may occur before or after a corporate event such as a merger.
Alternative investments are lowly correlated to the other investments, and what’s great about those is if we do hit troubled times, when the market struggles and the economy struggles, alternative investments behave dissimilar to more traditional assets. They don’t perform with the market, and they can actually perform opposite of the market. So, if we do hit a disruption in the economy and the markets, these should perform well and reduce the volatility of the portfolio. Some people choose fixed index annuities instead of alternative investments, which do not have the downside volatility that investing in stock market indexes does.
There are presently no actively managed investments or alternative investments in TSP, but if you have other investments outside of TSP, you may want to diversify them into actively managed investments and alternative investments.
All too often, when doing an investment review for a client that has other investments outside of TSP, I find that they are invested in the S&P 500 index and other similar passive investments to the TSP. Why not utilize TSP for your passive assets for a very low fee, and have assets outside of TSP invested in a way that will reduce your overall volatility to your investments?
As you are aware, the TSP fee is extremely low, but you are simply following an index, and the size of TSP along with indexing enables TSP to offer extremely attractive options for the passive side of investing. Good diversification strategies that align with your risk comfort level are always a good idea, just like the car with the gas pedal, brake and steering wheel, may prove to be a wise decision. They are even more important as you approach and eventually enter into retirement.