Feds – Don’t be alarmed. If you’re a new hire or are opting for TSP ‘L’ Fund allocation based on your age, your TSP asset allocation has not become more ‘Risky’.
Here’s what you really need to know about ‘risk’ when it comes to investing in TSP:
If you were hired prior to September 2015, your TSP went in to an allocation that was 100% G Fund. This is not horrible, as G Fund “has never had a bad day” (in the words of TSP Director Gregory Long), and since its inception in 1987 the G Fund has outpaced inflation.
As of the most recent pay period, new Feds have their TSP automatically allocated in to an age-appropriate Lifecycle ‘L’ Fund – Which automatically adjusts your stock/bond/G Fund allocation based on your age.
Here’s why the first article on GovExec misses the mark when it states that new Fed hires have been shoved in to more ‘risky’ assets. You see, there’s all kinds of risk. Even if you stuff your cash under a mattress, you’re accepting a particular type of risk (more below).
There’s multiple types of risk, each with its own source (or ‘forcing function’).
The two major Categories of Risk are Systematic (non-diversifiable) Risk and Unsystematic (diversifiable) risk.
1) Unsystematic risks are uncertainties taken on by a particular business (or a particular stock/bond). Unsystematic risk is also referred to as ‘diversifiable risk’ because an investor can reduce these risks by investing in different companies in different industries. Unsystematic risks are made up of:
1a) Business risk – Risk from the type of business undertaken and the competitiveness of the products sold (i.e. will Southwest Airlines do as well as United Airlines based on its business model and the airline industry’s overall outlook).
1b) Financial risk – Business risks are magnified based on the amount of leverage taken on by the company. Leverage magnifies the effects of both profits and losses (i.e. does Southwest Airlines have more risk based on its debt load vs. United Airlines).
In case you have not figured it out, if you are invested in the TSP you don’t have to worry about Unsystematic Risk and its sub-risks above, as the TSP diversifies investments in index mutual funds and does not allow you to purchase individual business securities (i.e. individual stocks or bonds).
However, as a TSP investor you DO have to understand Systematic Risks.
2) Systematic Risk refers to that which an investor is exposed to by being invested in any market in general. Systematic Risk has its sub-risks, which include:
2a) Market Risk – Risks in the day-to-day swings of an asset’s value, as priced by the market. Unlike a home or small business, TSP’s mutual funds are priced on a daily basis. Their daily value (price) is at the whims of the market (which may or may not be rational).
2b) Interest Rate Risk– Risks involved with how the value of an asset is affected by changes in interest rates. When interest rates rise, bond prices fall. Based on the fact that short-term interest rates are near zero (at the time of this writing), the TSP’s F Fund carries considerable Interest Rate Risk.
To be even more specific, the TSP F Fund is a proxy for the former Lehman Brothers Aggregate Bond Index (Ticker: AGG). The ‘duration’ of F Fund (AGG) is presently 5.22. This means that if the Fed raises interest rates by 1 percent, then the value of the F Fund/AGG drops by 5.22 percent. The F Fund/AGG’s current yield is 2.28% – Are you feeling lucky? (Note that current G Fund yield is 2.125%, with little to no Interest Rate Risk).
2c) Re-investment Risk – Risk that assets re-invested may not perform as well as the original investment. Your dividends or income from TSP’s mutual funds that are re-invested may not perform as well as they have in the past.
2d) Purchasing Power Risk – Risk that purchasing power will be eroded over time by inflation. If you stuff your money under a mattress, or if the G Fund does not continue to keep pace with Inflation, you are accepting Purchasing Power Risk in the G Fund.
2e) Exchange Rate Risk – Risk that the relative value of an asset may change based on the valuation or devaluation of the country’s currency it is based upon. This one affects mostly the TSP I Fund. If the value of the Euro tanks in relation to the US Dollar, then the value of most of the assets in the TSP I Fund (as priced in their native currency- the Euro) will also tank.
So now you have a better understanding of the Systematic Risks you’re exposed to in the TSP. Even the most aggressive of TSP ‘L’ Funds – L 2050 (which is aimed at employees younger than 25 who don’t anticipate retirement until at least 2045) – Still has an allocation of about 10 percent in the G Fund and 5 percent in the F Fund. You can see more about TSP L Fund target allocations here.
Disclosure: I’m not invested in any of the TSP ‘L’ Funds at this time, as I believe the G Fund is likely to provide a better near-term return than the F Fund (due to the F Fund’s severe exposure to Interest Rate Risk mentioned above in paragraph 2b).
For more reading about Investing Risks:
Mayo, Herbert B. “Investments: An Introduction“. New York: Dryden Press, 2014.
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