This article first appeared as a guest post on Ryan Guina’s Military Wallet.
Why Thrift Savings Plan Has Enough Diversification
A solid investment approach requires a balanced, well-diversified portfolio. Many people dislike the Thrift Savings Plan (TSP) because they feel it isn’t sufficiently diversified. Although TSP TSP only has 5 investment funds, (not counting the Lifecycle funds, which are target-date funds), this article will illustrate that TSP has sufficient diversification for just about any portfolio. That said, this article will only provide a basic level of understanding to everyday investors. Its purpose is not to explain complicated investment theories.
What is Diversification?
Before we discuss TSP, it might be worthwhile to explain diversification itself, and its role in reducing investment risk. According to Investopedia, diversification ‘smoothes out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others.’ It’s important to know what role unsystematic risk (also known as diversifiable risk) plays in investing. Below are a couple more definitions:
- Unsystematic risk: Company-or industry-specific hazard that lies in each individual stock or bond.
- Systematic risk: The risk asssociated with the entire market. Also referred to as beta.
- Total risk: Unsystematic risk + systematic risk
In other words, diversification only reduces the impact that one stock’s performance has on the market. It does not reduce the systematic risk that exists when you put your money in the overall market. Let’s look at two examples:
Investor A has a $1,000 portfolio that consists of 10 stocks, each valued at $100. Investor B has a $1,000 portfolio, with 100 stocks, each valued at $10. A year later, let’s say that in each portfolio, all the stocks went up by 10%, except for one company in each portfolio that went bankrupt, and their stock became bankrupt. Now, each Portfolio A winner is $110, and each Portfolio B winner is $11. Here’s how the new portfolio would look:
- Portfolio A: 9 X (110) + 1 X (0) = $990
- Portfolio B: 99 X (11) + 1 X (0) = $1,089
You can see that Portfolio A’s bankrupt company caused the overall return to be -1%, while Portfolio B still managed an 8.9% gain. Here lies the power of diversification—one company’s bad performance is overcome by the good performance of more companies in the portfolio. However, if a terrorist event occurs, or we enter a global recession & the overall market goes down, that overall effect, known as systematic risk, will generally happen regardless of your portfolio’s diversification.
What Constitutes Sufficient Diversification?
There is a lot of research on diversification, and specifically, how many different investments a portfolio should have before it’s sufficiently considered to be sufficiently diversified. One common academic answer is that impact of a single stock on a randomly selected portfolio goes down significantly after you reach 30 stocks, and is no longer statistically significant after 1000 stocks.
What are TSP’s Investments?
TSP funds come in 5 different funds: G, F, C, S, & I fund. Let’s look at how many securities are in each fund, according to their information sheets.
G Fund: G fund’s rate is calculated by the U.S. Treasury as the weighted average yield of approximately 125 US government securities on the last day of the previous month.
F Fund: Index fund that tracks the Barclays Capital U.S. Aggregate Bond Index. As of TSP’s last report, this index had 9,079 different government, corporate & non-corporate bonds and asset-backed securities.
C Fund: Index fund that tracks the S&P 500 Index, which contains securities from the 500 largest U.S. companies.
S Fund: Index fund that tracks the Dow Jones U.S. Completion Total Stock Market Index, which includes all of the actively traded U.S. stocks not in the S&P 500. As of TSP’s last report, this index contained 3,274 common stocks.
I Fund: Index fund that tracks the Morgan Stanley Capital International EAFE (Europe, Australasia, & Far East) Index. As of MSCI’s last report, this index tracked the stocks of 926 different companies located in 21 countries.
How is TSP Diversified?
If you count all the different investments, you get 13,904 different securities. Furthermore, these securities are diversified in terms of market capitalization (company size), industry, sector, and type of investment (stocks vs. bonds). There are a couple of shortfalls:
- No investments in Africa-owned companies. EAFE does not track markets in Africa. However, few, if any, African securities markets effectively regulate their investments or provide liquid (easily marketable) investments.
- No investments in master-limited partnerships or non-traded securities. MLPs and non-traded securities are considered illiquid assets, so it’s difficult to buy & sell investments at a price close to their value. This has an impact.
- No options, commodities (such as precious metals or oil), or futures. These are all highly speculative markets, which are not considered safe to invest in.
- No investments in speculative (a.k.a. junk) bonds. The F fund only tracks investment-grade bonds.
- No investments in preferred stocks.
- No investments in mortgage-backed securities, credit default swaps and collateralized debt obligations. If you don’t understand any of these terms, these are the investments that led to the mortgage crisis and the 2008 recession. It seems that most of the banking industry didn’t understand these terms either. All of these investments have one thing in common—if you’re an average investor, you don’t need to be investing in any of them. In fact, most professional investors don’t make them, either.
The Bottom Line
You could argue that there are still some safe investments that are not available in TSP. However, you will probably find that staying in the TSP portfolio will provide enough investment options for most people. Specifically, the TSP Lifecycle family of funds goes one step further. Lifecycle funds invest in each of the 5 funds based upon your desired time horizon. In fact, your next investment outside of TSP will probably end up duplicating the investments you already have in TSP. However, you’ll pay more, either, through either trade commissions or higher management fees, than you would by staying within TSP.
As always, this blog serves to answer your questions and address concerns. If you like this blog, please forward it on to other people who may benefit. If you have issues or concerns, or if you have a question you’d like me to answer, please feel free to contact me. You can reach me through my website, or via email. In the meanwhile, take charge of your life!