Chances are you are at least passingly familiar with the overall idea of Modern Portfolio Theory. Doesn’t sound familiar? How about, “Don’t put all of your eggs in one basket?”
The general idea — that a good way to manage risk in your portfolio is to hold a variety of different types of assets — is pretty much intuitive, despite the Nobel Prize-winning math behind it. With that principle in mind, it may be the case that your TSP account is spread over the alphabet of TSP funds (G, C, S, F, and I). But how did it come to be that way?
If you use a Lifecycle (or L) fund, the distribution between the different fund choices is defined for you automatically and kept in proportion based on the target year of the fund that you chose. The further away you are from your intended retirement date, the greater the emphasis on stocks in the portfolio. However, as the years pass, this bias towards stocks gradually lessens; this is referred to as the fund’s “glide path.”
Alternatively, you could construct your portfolio yourself, blending just the right amounts of each fund to create the bespoke cocktail that is your retirement investment plan. Which approach is best?
The Difference Between Asset Allocation and Diversification
While we probably agree that the basic philosophy underlying your basket of eggs is well-understood, there are important details to be considered. First among these details is the difference between asset allocation and diversification.
Asset allocation refers to how you distribute your portfolio between entirely different classes of investments. In the case of TSP, it is the difference between the G and F funds (bonds) and the C, S, and I funds (stocks).
Even the most casual TSP investor is likely aware that, generally, the bond market reacts differently to the economic environment than stocks, and that bonds are usually less “risky” than stocks. That is, bond investment returns are (again, generally, usually) less subject to wild swings in value than stocks. For that reason, many investors prefer to have some portion of their TSP account invested in G and/or F funds.
Diversification, on the other hand, refers to differences within an asset class. It is, for example, the difference between C and S and I. The stock of different types of publicly held corporations react differently to changes in the economy. A large US corporation (represented by the C fund) will share some characteristics of a small US corporation (represented by the S fund), but not all. Similarly, a non-US corporation (represented by the I fund) will not have the identical reaction to economic events as a US firm. For that reason, a properly diversified stock portfolio would tend to have slices of each: C, S, and I.
A properly constructed portfolio must not only account for asset allocation but diversification as well.
Even Passive Investors Have to Be Active Sometimes
So far, so good. But alas, having decided on your ideal personal recipe — based on your objective capacity to take risks in your investments, your emotional wherewithal to do so, and your understanding of the individual characteristics of the various investment choices — you must work to keep everything in alignment.
Consider if, on January 1, the overall value of your portfolio is $100,000, split evenly between stocks and bonds. Come December 31, the stock market has rallied by 10%, but your bond position has gained only modestly, just 3%. Your overall account is now worth a very satisfying $106,500…but $55,000 of that (52%) is represented by stocks. Unwittingly, you have moved away from your desired 50/50 asset allocation. What’s more, within the stock portion of your holdings, perhaps the stocks of smaller companies have greatly outperformed others. So whatever balance you had deemed appropriate between C, S, and I is now out of whack.
Rebalancing is when you sell some of one type of investment and buy some of another to keep your overall portfolio at its intended composition. Opinions vary, but most investment professionals seem to agree that rebalancing is something that you need to undertake once or twice a year, depending on how much the market has moved your portfolio away from its intended alignment.
Is a Lifecycle Fund the Right Answer for You?
To recap: “DIY diversification” looks like this: deciding on not just the “right” split between stocks and bonds in your portfolio, but what kinds of stocks and bonds, and then taking action periodically to maintain that balance. (And, of course, reconsidering from time to time if the allocation decisions you have made are still in line with your risk preferences as the years pass.)
For some, that’s no big deal and perhaps even enjoyable. For others, it feels like work best left to someone else. No wonder that L funds, and target date funds in general, have surged in popularity. In an L fund, the portfolio is continually rebalanced to its target allocation by automation.
Here’s the most surprising part: the computer that determines your L portfolio doesn’t ask to be paid for its effort. Specifically, the average expense ratio to assemble on your own a portfolio identical to the L 2045 fund is .0655%. The L 2045 fund has an expense ratio of .066%. In this case, buying L 2045 or buying its components on its own would cost you virtually the same, about 66 cents per $1000 invested. TSP does not exact a toll for the use of its L funds.
Should you decide that DIY is not for you, please don’t choose your L fund blindly. Look under the hood and consider if the recipe they devised for your intended retirement year actually suits your risk personality. If not, consider moving out in time to a further Lifecycle year to take on more risk. Or move “in” as needed to reduce the amount of risk in your account to a level that is comfortable for you and consistent with your goals.
But whether you leave the heavy lifting to the L fund or go DIY, never lose sight of the fundamentals. The single most important determinant of your retirement investing success is contributing enough to your TSP, consistently throughout your federal career.
Lisa Whitley is an Accredited Financial Counselor (AFC®) and Chartered Retirement Planning Counselor (CRPC®). After an 18-year federal career, Lisa became a personal finance coach & planner in 2019. Her firm, MoneyByLisa, is a Registered Investment Advisor domiciled in the District of Columbia.