Ask The Experts: Money Matters

By Mike Miles

Two ways to diversify and reduce investment risk

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Diversification. It’s a concept every investor responsible for managing a portfolio for retirement income must understand and use to his advantage.

Over the past 15 years, there have been calls from participants to add all manner of specialized investment funds to the Thrift Savings Plan — Internet, real estate, energy, gold, health care or any other market that has been hot — in the name of diversification. Ironically, these calls for more ability to diversify wouldn’t really provide that to any appreciable extent. Instead, adding these kinds of funds will, more than anything, allow participants to concentrate their portfolios in riskier assets and degrade expected performance characteristics.

These calls for new funds in the name of diversification, along with a lack of any audible response from participants or observers pointing out the error in defining diversification, is evidence that diversification is not clearly understood by many. It’s diversification, though, that makes it possible to manage your TSP account in a way that will reliably produce the maximum income possible over your lifetime. This is because volatility in your account’s value is the enemy of predictable income, and diversification is the best way to manage volatility.

Every investor should be using two basic types of diversification, as appropriate:

  • Intramarket, or within-market, diversification. This means owning more than one security of a given type at a time. It reduces the risk associated with an individual security without reducing the expected rate of return for that type of security. If you own one large company stock, for example, you are bearing all of the risk that the company might fail to deliver the expected results, even though the market for large company stocks does not. Own two large company stocks and you reduce that risk by half. Own three and you reduce it by two-thirds. Own the C Fund, instead, and you reduce the risk to 0.2 percent of what it would be with only one stock. By owning fully or widely diversified index funds, you can minimize the security-specific risk you face without significantly reducing the expected rate of return for an asset type or your portfolio as a whole. The TSP’s funds, as market index funds, are inherently well-diversified within the markets each fund represents, so they are foolproof in this aspect of portfolio construction.
  • Intermarket, or between-market or types of securities, diversification. Like its intramarket cousin, it is a means to reduce portfolio risk. The idea is to combine securities from different markets — like stocks and bonds, for example — in ways that tend to reduce portfolio risk more than they reduce the expected rate of return. Stocks tend to have a higher expected rate of return than bonds, but their prices tend to move in opposite directions at the same time.

Combining these two assets in a single portfolio averages their expected rates of return to give the portfolio an expected rate of return between that for each of them on their own. But, since when one is up, the other is often down, and vice versa, mixing them tends to smooth out the bumps that come from market fluctuations. In many cases, a less volatile portfolio with a lower rate of return will actually support a higher income stream than a more volatile, but higher-returning, alternative.

When managing money for retirement income, risk is the primary concern, not return. The TSP, through its five basic funds, offers you exposure to well-diversified markets in stocks, bonds and cash, the only tools you need to construct a well-diversified and risk-efficient portfolio. Carving out and concentrating your investment in narrow slices of the larger investment universe, like the “hot market” examples I mentioned, doesn’t increase diversification beyond what is already available in the TSP. Instead, it reduces diversification. It concentrates risk, increases volatility and reduces risk-adjusted expected rates of return.

In short, it’s counterproductive to maximizing a predictable income stream from your account. Add to that the likelihood that adding funds will only add costs and you can see why the TSP has been reluctant to allow new funds to its lineup.

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