These issues apply to all the TSP funds, but we will look at the problems through the Lifecycle funds. Does anyone really think you can just pick a fund based on your retirement date and let it ride in a market driven by wall street without any problems. If you are looking for mainstream marketing-deep thinking on investing, you are not going to find it here.
I hear it all the time…
Just signup for the Lifecycle fund that corresponds to your years to retirement and forget about it. How easy.
Yes, how easy.
I have three issues with the Lifecycle funds:
- Extreme market valuations do not matter to their allocations
- Defining risk as simply “volatility” does not equal reducing significant losses
- Geographic diversification under-weights global technology
These issues are not limited to Lifecycle funds. Many advisers do the same thing but charge higher fees for all their “hard work”. The Lifecycle funds were designed by consultants using the best academic portfolio theory from the 70s and frankly, the real-world never mattered.
The TSP Lifecycle Funds are managed as buy and hold funds that do not care where we are in the market cycle or what’s going on with interest rates. The TSP Lifecycle factsheet provides a pretty chart of expected returns for each fund without really explaining that “expected risk” across the bottom axis. [My comments in blue]
Second, if they did explain “risk” it would involve the academic idea that volatility equals risk. According to this theory, you reduce the “risk” in your allocations by simply adding less volatile funds such as the TSP F and G fund.
But guess what reducing volatility really means.
It means that while you lose less in a down market, you gain less in an up market. If your account balance is less volatile then by the TSP consultants definition it is less “risky”.
Take a look at the funds below and see how this has worked out since the market top in 2007 – a full market cycle. The Lifecycle funds (dotted lines) are circled in orange. Yes, they lost less in the bear market, but they made less in the bull market. They caught up to the TSP G fund about the same time as the C and S fund, but look at where you ended up.
Before you decide to throw it all in the TSP S fund and let it ride, you may have noticed I added some comments about the market’s valuations today – something the Lifecycle fund allocations are oblivious to. Most retail investors are oblivious too which is why they jump in near the top when those 3 and 5-year past returns look so great.
One would think that since the stock market has lost over 50% of its value twice since 2000, the TSP financial consultants might mention that your future returns depend a little bit on approximately where we are in the valuation cycle the market.
The “efficient frontier” lives in a world where somehow the TSP Lifecycle Income fund will earn 4.5% largely in TSP G and F fund. Both of these funds have averaged about 2% yields over the last 10 years.
While it is possible for the TSP G fund to rise back to a 4.5% yield if interest rates keep climbing and all hell is allowed to break loose in the stock market, the TSP F fund would sustain a 10% capital loss during the same time.
This means 0% total returns for the F fund for a couple of years, then you can have your 4.5% yield.
Taking all this into consideration, I added in a more realistic expected return curve (circled in green) for the next 10-12 years.
You might have noticed my curve descends as you move out in time on the Lifecycle funds. This is due to the higher levels of equities in the funds the further out you go. It is possible the Income fund could earn 3% or higher with its heavy allocation to the G fund, but I am also expecting interest rates to get slammed lower again after the next financial crisis hits.
My curve best corresponds to the 2030 Lifecycle fund since I am only looking out 10-12 years. While the static “Efficient Frontier” is telling you to expect over 6% by 2030, if you take market valuations and current interest rates into account (the real world) my curve has the L2030 fund’s expected return a hair above 0%. It will be above zero thanks to being pulled higher by the always positive TSP G fund’s return.
If you can’t imagine the stock market today with all the positive news losing over 50% and being no higher than today in the next 10 years, take a look at the TSP Fund Price Progression chart above where I added in the TSP C fund companies’ sales growth (white line). To return to the 2007 market top’s Price-to-Sales ratio, the TSP C fund price would have to lose 50% relative to sales.
And in 2007, the TSP C fund’s price needed to lose 40% to return to the historical average ratio. In other words, if the TSP C fund’s price dipped 70% it would merely be back to average historical valuations based on revenue. I am not saying this will happen, but another 50% haircut is not out of the question.
If you think I am off my rocker on valuations, you should take a look at the following two links now…
During the last bear market, the ratio merely dipped slightly below the average historical Price-to-Sales ratio. And then the global central banks started creating money out of thin air and buying financial assets up hand-over-fist to repair the balance sheets of the banks. It was this massive removal of supply of financial assets that sent global stock markets up and interest rates down, certainly not the economy or corporate profits.
I also hear just buy and hold because the market always comes back.
It’s true, most funds broke even five years after 2007 thanks to the price-insensitive central banks buying. But this is not always the case. Please note, the 2012 level was the same level as in 2000 which was 12 years earlier. It took exceptionally longer after the 1929 peak and Japan is still waiting to return to the Nikkei’s 1989 level.
Extremely over-valued markets take much longer to break even, possibly longer than your retirement horizon. Especially since all the central banks really did was to dig a deeper debt hole for us to to climb out of.
I mentioned I had three issues with the Lifecycle funds.
The first issue was they are buy and hold funds no matter what the market valuations are. Second, they reduce volatility but not the risk of significant market losses. The third issue is the funds are geographically diversified in terms of stock exchanges (think I fund) which results in being under-weighted in the #1 global growth sector – technology.
The bottom line is the TSP C fund companies derive 38% of their revenue outside the US. This means the TSP C fund is already diversified globally in terms of revenue. Adding the TSP I fund (purple plot below) to the mix over-weights the under-performing international markets.
The TSP C fund’s technology sector derives 70% !!! of its revenue outside the US. The International fund only has a 7% technology weighting versus the 26% weighting in the C fund and 18% in the S fund – in other words if you want global tech, you hold the US equity funds.
And you want to own global tech companies.
I go into more detail on the issue of diversification in my series on the Best TSP Allocation and Strategy if you have not already read it before.
Did you notice the difference in the two charts of the TSP fund’s price progression since 2007?
The first chart is deceiving in that stock market losses look small compared to the gains of the bull market. In the logarithmic chart above, all percentage changes look alike – this better highlights how deep the stock market losses really were in 2008. A 50% loss does not equal a 50% gain, it equals a 100% gain (to break even). Avoiding large losses matters immensely.
A Better Way
Take a look at this chart and tell me if you notice a trend. It shows the average price progression of the SP500 (TSP C fund) from 1950 to 2011. It’s one of our older charts, but it makes the point.
The point is that you can capture most of the stock markets gains in half the year and capture risk-free interest in the TSP G fund the other half. Since the chart above is average progression, the concept works long-term and not exactly the same every year.
Now that the TSP G fund’s interest rate is approaching 3% and the stock market valuations are approaching the sun, it makes even more sense.
We’ve designed a Seasonally-Modified Buy & Hold strategy around optimizing the seasonal effect. It only holds stocks during those climbing months.
It’s the only strategy we found to increase returns over passive investing in low-cost market funds over full market cycles. It does this not by taking on more risk as those efficient market yahoos would have you do, but by decreasing risk during the half of the year that is the worst performing for the stock market as seen in the next chart.
Higher returns and better sleep.
It does require you to log into your account twice a year to make the allocation changes. But it will be worth it. BTW, we send our members an email to tell them when our Bellwether signal says the favorable and unfavorable seasons begin. It is not the same day each year – it is a bit more advanced than that.
I believe investing objectives should be twofold: 1) avoid large corrections and bear markets and 2) invest when the conditions are most favorable.
If this makes sense to you, you might want to become a TSP Smart Investor member since Lifecycle funds will do neither for you. You will also get a chance to hear more of my non-mainstream market commentary posted on my website at your leisure – not via spam.
You can find more details on our Bellwether Results page and how it worked with all the TSP funds. If you would like e-mail alerts for meeting these two objectives list above, you can check out our low-cost basic service.
While we do not recommend trading your retirement account, serious investors might be interested in our TSP trading day almanacs for the C/S/F fund. They now include the effects of options expiration’s. I also found an interesting pattern in the TSP F fund some retirees might be interested in.
Michael H. Bond
TSP & Vanguard Smart Investor helping TSP investors invest safe and smart since 2011.