Now that you have a good understanding of the available TSP investment options and historical risks and returns of the various TSP funds, you may be wondering how to actually invest in the Thrift Savings Plan. What's a good investment strategy? How do you decide which funds to allocate your savings to, and how much?

Broadly speaking, there are two different approaches to answer these questions. You can choose a strategic asset allocation, or a tactical asset allocation. Let's take a look at each of these investment strategies in turn.

Strategic Asset Allocation

Strategic asset allocation is sometimes referred to as “buy and hold” or a “passive indexed” approach to investing. The basic idea is that you first determine your investment horizon (when you expect to retire), and risk tolerance (how much you can stand and afford to lose).

You then evaluate the historical returns and risks associated with the funds and asset classes that you are investing in (in this case the five TSP funds), and determine which specific portfolio combination is optimal for you. Now you can go ahead and allocate your TSP account using these specific percentages of stock and bond funds.

Let's illustrate this with a hypothetical example: Homer, a relatively inexperienced TSP investor, had saved a total of $10,000 in his Thrift Savings Plan on 3/9/2009. On this date he owned a simple stock and bond portfolio with $6,000 worth of C Fund shares, and $4,000 in the F Fund. We'll assume that this is his target asset allocation: 60% stocks (C Fund) and 40% bonds (F Fund). If Homer had just left his funds alone since then, and not made any further contributions, this is what his account would look like less than three years later on 1/26/2012: the value of his C Fund shares would now be $12,433 and the F Fund shares would be worth $4,959. To use a technical term, Homer’s portfolio allocation is now way out of whack! He’s holding 71.5 percent in stocks and 28.5 percent in bonds. To bring these back to his target allocation, he’d have to sell enough of the C Fund to bring it down to 60%, and invest the proceeds in additional F Fund shares to bring those up to 40% of his total account value. Luckily, the website provides a nifty Interfund Transfer (IFT) page where all you have to do is plug in the percentages you want to hold in each fund, and the TSP will take care of the rebalancing math and fund share exchange for you.

A more sophisticated passive indexed portfolio would further diversify the stock allocation, holding slices of the C, S, and I funds. This would add portfolio exposure to international stocks (I Fund) and small cap stocks (S Fund), which have historically both added some amount of additional return and are not perfectly correlated to U.S. large cap stocks (C Fund). Another option would be to allocate a portion of the account to the G Fund, which provides risk-free fixed income.

Fluctuations in asset prices are very common (especially in riskier securities such as stocks), and most advisors would recommend that you rebalance your “buy and hold” portfolio about once every calendar year. You can also use monthly plan contributions for this: figure out which of your asset classes are currently under-valued (based on your target allocations), and allocate more to those.

Diligently allocating to under-valued funds is one of the few “edges” that a buy and hold investor has: time diversification. If you follow this strategy, it is important to stick with it during both good times and bad. Yet this has proven to be one of the great practical weaknesses of strategic asset allocation. It can be very difficult psychologically to continue to plow money into an asset class that declines in value, month after month, sometimes for years on end. And many studies over the past decades have shown that on average, investors are not successful at doing this. For example, one annual study by a company named DALBAR shows that investors badly under-perform the average returns of indexes. In their most recently published results, they report that for the twenty-year period ending in 2010, stock investors earned 3.83% compared to the S&P 500 return (equivalent to the TSP C Fund) of 9.14%. For the same period, bond investors earned 1.01% compared to the Barclays Aggregate Bond Index (equivalent to the TSP F Fund) return of 6.89%. There are many reasons for this, among them the fact that investors hold their stock funds for an average of slightly over 3 years, not exactly what you would call long-term “buy and hold.” Other studies have shown that investors also tend to sell at the worst possible times (near bear market bottoms, after stocks have already gotten hammered), and buy back in near market tops (when investors are most bullish). A number of psychological biases have been suggested as the cause of this poor investor behavior.

Tactical Asset Allocation (TAA)

Tactical asset allocators aim to be invested in an asset class only when it is attractive (for example, when prices are rising). Rather than investing in a static (strategic) asset allocation, they adjust the weights in their portfolio (which assets to invest in and how much of each) according to either a discretionary or systematic investment strategy. A good example of a quantitative (purely systematic) TAA strategy is our own TSP Folio strategy.

When all asset classes are on the rise — such as for example during much of the 1990s — it is very difficult to exceed the returns of a passive asset allocation. But during other decades, such as 2000-2010, the reverse is true. During this period, stock investments (like those in the C Fund) experienced large price swings, both up and down. But by the end of 2010, stocks had only advanced by 1.37% per year, far short of their historical average of 9.32% compound annual gains since 1900. A simple tactical strategy that invests in equities when they are on the rise, and side-steps them when they decline, investing instead in bonds and other asset classes, would have performed much better during this period. Interested investors can learn more about how our own strategy accomplishes this, or read any of the fine academic and practitioner research on TAA, such as the work of Mebane Faber.

In our opinion the primary aim of tactical asset allocation should not be greater absolute returns (although that can be a nice side effect during some periods), but rather better risk-adjusted returns. To continue the example of the decade of 2000-2010, a buy and hold investor with a 60% stocks / 40% bonds portfolio would have suffered through two bear market declines in 2001-2003 and 2008-2009, high volatility, and a 29% maximum drawdown in portfolio value (percentage decline measured from the peak in 2007 to the trough in 2009). All that for a meager 1.37% compound annual return. By contrast, the TAA strategy would have breezed through the decade with a relatively benign 8% maximum drawdown and a compound return of over 10% per year.

Which investment strategy is better?

The answer is different for every investor; there is no “one size fits all” solution. We suggest that investors first learn everything they can about the pros and cons of both strategic and tactical asset allocations, and determine which approach is more appropriate for their personal situation. From there, you can then narrow down the field to a specific investment strategy and portfolio. As always, if you don’t feel comfortable making these decisions on your own, seek the advice of a qualified investment advisor (which we are not). [Disclaimer]