THIS IS AN ARCHIVE POST. CLICK HERE FOR THE CURRENT TSP ALLOCATION GUIDE UPDATE.
I recently had an interesting conversation with a colleague about the roller coaster ride the stock market has been on over the past year. He very proudly announced that he had missed all of of the turmoil because he had moved to the G Fund last August and had recently come back into the C Fund now that it was going back up again. He was absolutely convinced that he had come out way ahead in his Thrift Savings Plan, but hadn’t actually done the math.
So I did it for him.
He, like so many other TSP investors, sold after the big drop last August. And bought back in late in March after the market had finally gone on a steady run, which convinced him that it was “safe” to get back in. (He went to the G Fund on August 24th and to the C Fund on March 30th to be precise.)
During that period he was in the TSP G Fund, which earned him a nice, safe 1.23%. In contrast, the TSP C Fund went up 10.56% during that same “terrible” period. The financial media and blogosphere sure didn’t make it feel like the market was up more than 10% during that time frame, did it? (The TSP S Fund was up 1.45% and the TSP I Fund was up 0.55% during that same period.)
So depending on what mix of C, S and I Fund he otherwise would have been invested in, my colleague missed out on up to 9.33% of gains during that seven month period.
That by itself is huge money – for most TSP investors that translates to tens of thousands of dollars. But that is just the present value of that difference. My colleague has at least 15 years left until retirement, so he also missed out on all of the future gains he would have obtained with that money.
Let’s conservatively say that he missed out on just 6% of gains, and he had a TSP balance of $300,000. And let’s conservatively say that he would have earned 8% on that money annually for the next 15 years. We plug that into our compounding formula: end balance = principal (1 + rate of return/number of times compounded per year)^(rate of return x years) – or if we are being lazy go to the compound interest calculator at: https://www.investor.gov/tools/calculators/compound-interest-calculator.
That $18,000 would have turned into $57,099 by the time he retired. And assuming he leaves at least a portion of that money invested well into his 30 year retirement, that could easily turn into six figures. How clever does he feel now?
But wait! There’s more! My colleague continued to make Thrift Savings Plan contributions during that seven month period – contributions which went into the G Fund. So during that time, he also missed out on the opportunity to buy stocks cheap, instead changing his allocation only now that the market is less than 2% below its all time high (which was May 21, 2015 – just so you don’t have to look it up).
So this is a good time to go back to one of the principals of my investing strategy – the concept that the best TSP strategy is to buy and hold the fund (or funds) which is most likely to do well during a given phase of the business cycle and stay with that fund until the business cycle dictates a change.
But why does that work? Why do stocks outperform other types of investments over the long term? And why does buying and holding outperform shorter term trading strategies? The difference in results I spelled out between my returns and those of my colleague above are just an anecdote, but all the research shows that stocks have higher returns than bonds over time, and strategies which keep the investor largely in the market outperform strategies in which they jump in and out.
Let’s start with the “equity risk premium.” All that means is that we get a bonus for buying stocks because they are considered more risky than some other types of investments.
When we buy stocks, we are going into the area of the financial system with the most risk in order to get access to the present value of the future earnings of a company. Why is it the area with the most risk? Because a company can go bankrupt and your stock investment can go to zero. Other types of common investments (such as bonds issued by the same company) outrank you if the company you have invested in goes under, and US Government bonds have virtually no risk at all. But by spreading your stock investments across a large number of companies (as we do in broad index funds such as the Thrift Savings Plan stock funds), that risk that your investment will be entirely lost is eliminated.
Stock returns consistently outperform bond returns because stock investors typically have a shorter time horizon for their investment than bond holders. Bond holders are willing to accept a lower rate of return for a safe, boring investment which does not change in value if you hold it to maturity. (Bond traders, on the other hand, are subject to as much volatility as stock traders). Stock investors, in comparison to bond investors, tend to be guided by something called “myopic loss aversion” – which causes enough of them to sell at the first sign of trouble to create the constant ups and downs of the stock market.
That selling feels bad if we look at our TSP balance every day or week or month, because we see what looks like our retirement savings getting smaller. But what looks like a bad thing is actually a good thing – that routine selling by “traders” means that a long-term passive investor like me can routinely buy stocks at a slight discount. That discount represents “the persistent equity risk premium embedded in stocks” – a fancy way of saying I get a bonus for taking a risk in buying a stock.
But if you want the benefit of the equity risk premium, you have to hold on through volatility in order to actually realize it. The traders won’t. You have to continue to buy when the market is down, and you certainly can’t sell after the market has suffered a downturn.
TSP performance year-to-date: (through market close on 04/22/2016)
• TSP C Fund: 3.05%
• TSP S Fund: 2.11%
• TSP I Fund: 1.08%
• TSP G Fund: 0.59%
• TSP F Fund: 3.13%
And the TSP LifeCycle Funds are very average for 2016 so far (just as they are engineered to be), ranging from 1.19% to 2.25%.
Last Month’s Economic Numbers:
In this section I will discuss the key indicator data I use in determining where I think we are in the economic cycle and what that data means to me in deciding how to allocate my Thrift Savings Plan balance. (These indicators are explained in some detail in How to Determine the Current Phase of the Business Cycle.)
To save some time and get this out, I’m going to give a quick and dirty summary of the indicators instead of going into depth as I usually do. Don’t worry, all the charts will be back next month.
Employment numbers: the unemployment rate in the United States remained at 5.0 percent in March, while total non-farm payroll employment increased by 215,000. I obtain this data from the Bureau of Labor Statistics.
Purchasing Managers’ Index (PMI): as usual, I pulled up the most recent report from the Institute for Supply Management. Any number above 50 indicates growth in manufacturing, and this month’s reading of 51.8% shows a nice rebound. This marked the third straight month of improvement in the PMI after six months of declines, and a sharply higher figure than last month.
Yield spreads: The yield curve spread out in March (which just means that the difference in interest rates between short term and long term bonds increased). Based on yield spreads, the Cleveland Fed says:
The increased spread did lead to a small decrease in the probability of recession. Using the yield curve to predict whether or not the economy will be in recession in the future, we estimate the expected chance of the economy being in a recession next March at 7.45 percent, down from the February number of 8.82 percent but up a bit from January’s 6.19 percent. So the yield curve is optimistic about the recovery continuing, even if it is somewhat pessimistic with regard to the pace of growth over the next year.
Money supply growth rate: Money Supply M2 (which includes savings deposits, money market mutual funds and other time deposits which can be quickly converted into cash or checking deposits) increased from February to March. The growth rate is what is meaningful here, and if I had my usual chart up you would be able to see a nice gap up:
Money Supply M2 in the United States increased to 12567.20 USD Billion in March from 12472.80 USD Billion in February of 2016.
All of which leads me to believe that we remain in the Mid/Growth/Performing stage of the business cycle and so I will complete the transition of the bulk of my investments to the C Fund, which has been the best TSP fund of 2016 (while maintaining my position in the I Fund). I also believe that the probability of the US economy entering a recession in the next year is low.
The TSP I Fund
I don’t do a full breakdown in this space, but I watch the indicators for Japan, the UK, Germany, France and Switzerland (which comprise the bulk of the TSP I Fund) in an attempt to divine the direction that index will go over the medium and long term.
- Japan: Japan indicators summary page
- United Kingdom: UK indicators summary page
- France: France indicators summary page
- Switzerland: Switzerland indicators summary page
- Germany: Germany indicators summary page
Continued Transition to the TSP C Fund
I see no reason not to continue moving most of the remainder of my Thrift Savings Plan investments to the C Fund to reflect where I believe we are in the Business Cycle. As soon as I hit publish on this post, I will be heading to TSP.gov to conduct an inter-fund transfer and to change my allocation to 85% C Fund, 15% I Fund.
With that change in place, I believe the odds are excellent that I will not change my allocation again this year, although I will certainly be doing my monthly pulse check to make sure we remain in the Mid Stage of the business cycle. And I may tweak my TSP I Fund allocation as we get closer to the Brexit vote (more on that next month).
I always try to remind readers that this is just what I am doing based on my circumstances, and isn’t a recipe for what anyone else should do with their Thrift Savings Plan. This is just food for thought, not something to mirror unless you have done your own research and considered your own circumstances.
This month’s recommended book is a new one by Steve Case, The Third Wave: An Entrepreneur’s Vision of the Future. Case, of course, was one of the cofounders of America Online, which was the top performing company of the 1990s. In this book he provides a fascinating history of the founding of AOL and the launch of the internet era, and draws parallels to the next era of change. For anyone who is interested in investing in the technology of the next decade or two, this is a fascinating read.
The Next Update
Unless something unexpected happens, I will send out my next update about this time next month. I send out a notification of these updates (or allocation changes during the month) to the email list which you can subscribe to here: Subscribe. If you want to see what I am reading throughout the month, I also have a twitter account to which I usually post items of interest which I have stumbled across for investors, Feds and the military a few times a week at: @TSPallocation
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