Tuesday, April 3, 2012

Asset allocation strategies for the Thrift Savings Plan

Asset allocation is as old as the bible, older in fact. For example, here’s a segment from the Talmud that’s over 3,200 years old: “Let every man divide his money into three parts, and invest a third in land, a third in business and one third let him keep by him in reserve.” The first two parts of this recommendation could be interpreted as investments in real estate and stocks. The third part is not quite as clear. Asset allocation guru Roger Gibson defines "reserves" as U.S. government bonds, whereas others believe that during those ancient Jewish times it would have referred to "silver." Regardless, the concept is crystal clear: spread your risks, and never put all your proverbial eggs in one basket.

The concept of asset allocation is really quite simple. Choose from a set of diverse investments which don’t always move up and down in tandem. Determine a risk level that you are comfortable with, and which is also acceptable based on your time to retirement. Consider all possible asset combinations whose risk meets your tolerance. Calculate the expected gains for each portfolio combination. Select the portfolio combination with the highest expected returns.

Simple though it may be in theory, asset allocation is challenging to implement in practice. For example, what risk level exactly are you comfortable with? How do you even define risk? And even for those scientifically inclined investors who can follow the mathematical calculations, a theoretical understanding of risk and potential losses is not at all the same as experiencing the real deal, as any veteran investor who’s suffered through a few recessions will tell you. Your own survival instincts are your worst enemy, and interfere at the worst possible moment.

Asset allocation for Thrift Savings Plan participants means choosing among the 5 basic TSP funds, or allocating your entire account balance to one of the predetermined asset mixes, the Lifecycle or “L” Funds. This last option is attractive to plan participants who don’t care about the specifics, but as with many choices in life, the easy road is not necessarily the superior one.

The 5 TSP funds are simply different kinds of bonds and stocks. The safest is the G Fund which invests in a bond-like security that is guaranteed not to lose any of your original investment. Its probable returns are therefore also the lowest. The other fixed income choice is the F Fund, which tracks an index of investment grade corporate and government agency bonds. These two bond funds are invested in domestic securities only. The remaining 3 funds are stock funds. The C Fund is held in an index consisting of large cap US equities. The S Fund tracks small cap US stocks. And the I Fund invests in foreign stocks in so-called “developed” markets. Choose well among these funds and you’ll have a decent equity and bond investment portfolio.

It may surprise you to learn that many TSP investors don’t even get this far. Casual conversations among co-workers reveal many who don’t even have a well-diversified portfolio of equities and fixed income, but rather plow most of their money in one concentrated asset class or the other. Some Feds allocate too much to the risky assets (all stocks), while others over-allocate to the conservative (all bonds).

But a knowledgeable investor shouldn’t stop there. As you get closer to retirement, you’ll probably very well own more investment accounts in addition to your TSP plan. After you’ve maxed out the annual contribution, those who still have additional savings can put these in a regular investment account. Or perhaps you have a working spouse who is not a Federal employee. Investors who are in this situation frequently ask: what do I invest those extra funds in? Once you go beyond a handful of TSP funds, things get a little trickier.

Now that you’ve got a basic U.S. stock/bond portfolio put together, consider allocating a portion of it to emerging markets stocks, for additional diversification. One well-chosen additional index fund will do the trick. A good option is Vanguard Emerging Markets Stock Index Fund (VEIEX).

Next you could add real estate, which also has historically shown low correlation to the basic TSP funds. The simplest adjustment you can make here is to add a Real Estate Investment Trust (REIT), such as the Vanguard REIT Index Fund (VGSIX).

Next, let’s take a look at alternative investments such as commodities. This is an asset class that’s often neglected. The simplest way to invest in commodities is by owning an exchange traded fund (ETF) that invests in this asset class. ETFs trade very much like stock shares, and you can buy and sell them through any online broker. For most TSP investors the most suitable commodity ETF is one that follows a broad index. One example of a commodity index fund is the Elements Rogers International Commodity Index ETN (RJI), but there are other funds that follow different indexes. For investors with larger portfolios, a small allocation to more granular commodities could make sense. For example, to benefit from rising prices in gold, you can invest in the SPDR Gold Fund (GLD). Or to follow the price of crude oil, try the PowerShares DB Oil Fund (DBO).

Keep in mind that you should always practice moderation and don’t put too much of your retirement into any one “basket”.