“What should I do with my Thrift Savings Plan?”
I get that question all the time. If you don’t know what the Thrift Savings Plan is, you can check out my post covering the basics of the Thrift Savings Plan here.
I always give ambiguous advice and never really answer that question directly. The people asking probably think I don’t really know anything about investing, but I have to be vague. I must because what they do with their TSP (Thrift Savings Plan) depends on several variables that could not possibly be known right there on the spot. Three of the biggest variables are an individual’s risk tolerance, their required return and where the efficient frontier is within the TSP. Risk tolerance and required return are unique to each individual, whereas the efficient frontier is common to everyone and is dependent upon market data. In this post, I will attempt to demonstrate where I believe the efficient frontier currently is and why you should probably want your TSP portfolio to be on the efficient frontier.
So what is the efficient frontier? The efficient frontier is the portfolio of assets which offers the highest expected return for the lowest amount of risk. In other words, it is an optimal portfolio where no other mix of assets will offer a better return at a given level of risk. So, while I may not know your exact individual risk and return profile, I do know that holding a portfolio that is on the efficient frontier is generally better than holding a portfolio which is not on the efficient frontier.
Before I present the results for my TSP efficient frontier, I need to explain a few things.
- The efficient frontier is unstable over time. It moves around. Different funds within the TSP perform better or worse at any given time. Don’t adjust your portfolio based on this blog post, it may be out of date.
- I used 10 years of monthly returns to create the efficient frontier below. Most people use five and some use three years of data. I used 10 years so that it would capture a full business cycle and include both a bull (up) and a bear (down) market.
- The efficient frontier is based on Markowitz Portfolio Theory (often called Modern Portfolio Theory or MPT for short) and has some very loud and brilliant critics. Much of the criticism centers around the fact that MPT assumes Gaussian (normal) distributions for asset returns and assets often do not have normally distributed returns.
- The other major criticism is that MPT is using past returns to project future expected returns and the risks to those returns. Anyone who has watched CNBC for more than five minutes has seen a commercial where some fund touts their great performance and end with the disclosure, “past returns do not guarantee future results.”
- The efficient frontier is for a TSP portfolio only. If you also hold stock XYZ and/or mutual fund ABC outside of the TSP, your efficient frontier will not be found in this blog post.
So, if there are all of these issues why should you want to be on the efficient frontier?
- Diversification. The whole idea of MPT is to eliminate nonsystematic risk (or non-market risk) from a portfolio. Okay, what does that mean? Nonsystematic risk is company or asset specific risk. The classic example is having 90% of your retirement savings in Enron stock before it dropped to zero. When nonsystematic risk is eliminated from a portfolio only systematic risk remains. This means that no single company or industry will annihilate your portfolio a la Enron.
- Portfolios holding nonsystematic risk receive zero extra compensation for holding extra risk. The market only compensates for market risk. Extra risk is the form of nonsystematic risk is just that, extra risk. Why take any extra risk without being compensated for it?
- MPT is relatively easy to calculate compared to many of the alternatives. A good illustration of this is while I was studying for the various levels of the CFA exams, MPT was present throughout and I had to memorize the formulas for MPT. Alternatives to MPT were only talked about and formulas were never presented. You can view the Black-Litterman model (the probable favorite of the CFA Institute) here if you would like. However, the TSP does not lend itself well to the Black-Litterman model because there are only five funds to choose from and Black-Litterman requires access to a worldwide portfolio which can be segmented by major markets. The TSP’s I Fund comes in a one-size-fits-all package and can not be segmented.
- MPT is theoretically correct. All other methods for creating optimal portfolios use MPT as a basis.
Taking all of the above into consideration, I believe it is reasonable to construct a TSP portfolio using MPT and I did. I created 9 portfolios. The first portfolio is an equal weight portfolio which is sometimes referred to as naïve diversification. Basically, the participant just says split my money evenly among the existing funds because I have no idea. This is the second most popular TSP portfolio I see. The most popular portfolio I see is 100% in the G Fund; I believe that 100% in the G Fund is the default allocation if you do not select otherwise which explains its popularity. Then I created the other eight portfolios which are laid out in the table below, color-coded according to their risk and return level. Green for low and red for high.
The Equal Weight Portfolio (EWP) is not on or even near the efficient frontier but it was placed in this group for a reason. It demonstrates the power of MPT and the folly of naïve diversification. The expected return of the EWP is .498% per month with risk measured by standard deviation at 2.944%. If we look at Portfolio Five we see that it offers a return of .565% per month with a standard deviation of only 2%. Portfolio Five dominates the EWP with a higher return at a lower risk. This may be better demonstrated in the graph below where all the portfolios are aligned with risk (standard deviation) on the x-axis and monthly return on the y-axis.
Notice how the EWP is below the blue line connecting the other eight portfolios. By the way, that blue line is the efficient frontier for the TSP. While there are certainly worse portfolios that can be constructed, I do not recommend naïve diversification. Some may point out that the EWP is more diversified because it holds all five funds and several of the portfolios on the efficient frontier only hold two or worse yet only one single fund. That is true, sort of, and it is one of the reasons why many prefer the Black-Litterman model. However, each of the funds within in the TSP are already highly diversified on their own. The C Fund is made up of the stocks of the 500 largest companies in America. Holding 500 companies is pretty diversified already. The S Fund tracks an index which holds over 3,000 stocks, which is diversification with a capital “D”. Additionally, not all funds diversify equally. Below is the correlation matrix for the funds in the TSP. A correlation of one means the funds move up and down together perfectly. A correlation of negative one means the funds move perfectly in opposing directions.
The C, S, and I Funds are all closely correlated. In other words, there is hardly any benefit to holding all three funds as they all move up and down together for the most part. Historically, the S Fund has outperformed both the C and I Funds. It has offered a higher return for lower risk. The Correlation Matrix is why the G, F, and S Funds dominate the portfolios on the TSP efficient frontier. Low correlations between assets are what we are looking for when we want diversification, not a certain number of assets.
So, what should you do with your TSP?
You should get your TSP portfolio on the efficient frontier.
Where at on the efficient frontier depends on your risk tolerance and return requirements. To answer those questions you should speak with your financial advisor.
My MS Excel spreadsheet for TSP portfolio optimization containing all 10 years of data and calculations can be downloaded here: tsp-optimization.
This blog post is for educational purposes only. It is not meant to be taken as investment advice for any individual. You should speak with your financial advisor before making any investment decisions.