FEDweek

2 Smart Methods to Preserve TSP Capital

Last week was the worst week for the Dow Jones Industrial Average in the last two years. Investors were spooked by higher-than-expected interest rates on 10-year treasuries and an equity sell-off resulted. We saw a spike in volatility and losses in equities throughout the week, culminating in a 666-point drop in the Dow on Friday.

Since we’re about 9 years into the second longest and second biggest bull stock market in U.S. history, stock valuations are already so high relative to their fundamentals based on several metrics, and we’re in a rising interest rate environment, it makes sense for investors to be cautious. We could certainly see more upside, but there’s plenty of downside risk at this point.

For readers with large TSP portfolios, this article describes two smart methods to preserve your money.

Method One: Buy, Diversify, and Hold

This is the ideal method for most investors to protect and grow their retirement savings, because it’s hard to go wrong.

Buy diversified index funds, preferably ones that re-balance themselves automatically like the TSP Lifecycle funds, and just keep putting money in every paycheck. When recessions and stock declines come, don’t change anything. When bull markets come, don’t change anything. Just keep adding money.

Over the past 20 years, the S&P 500 averaged 7.7% annualized returns, while a 60/40 stock/bond split portfolio averaged 6.9% returns. This is almost as good, but with way less volatility.

Here’s a chart of 100% stock returns compared to 60/40 and 40/60 stock/bond portfolios since the previous market top in 2007:

Source: JP Morgan Guide to the Markets, 2018 Q1

The total growth was similar, but the balanced portfolios were less volatile, had smaller drawdowns, and recovered to surpass their previous peak more quickly. If you add fresh money each month, the time to recover is even faster.

The TSP is more diverse than this, because in addition to stock and bond funds, it has some exposure to international equities via the I Fund. And in 2019, the TSP board plans to broaden the I Fund to include emerging markets, which should improve the fund for the long-term by giving it more geographic diversification and exposure to faster-growing economies.

Buying and holding a TSP lifecycle fund makes stock market declines less scary without sacrificing much long-term growth compared to pure equity portfolios.

Method Two: Monitor Moving Averages

For hands-on investors, there is a reasonably well-evidenced way to reduce big losses in your portfolio, but it’s not without risk.

Mebane Faber, the chief investment officer of Cambria Investment Management, published a paper in 2006 called “A Quantitative Approach to Tactical Asset Allocation” that outlined a timing model based on moving averages, which he continues to update every few years. This is one of many tactical asset allocation methods, and it’s one of the simplest and most applicable to the TSP.

The idea of the model is to hold a group of different asset classes and sell an asset class if it drops below its 10-month moving average. Most applicably for the TSP, if the S&P 500 drops below it’s 10-month moving average, significantly reduce your exposure to the C and S Funds. And if the MSCI EAFE drops below its 10-month moving average, significantly reduce your exposure to the I Fund.

This chart shows the S&P 500 and its moving average over the past 20+ years, with red highlighting the periods where the S&P 500 is below its moving average and the model would reduce or eliminate exposure to equities:

Source: Advisor Perspectives (Updated Monthly)

This strategy would have protected you from most of the downside losses during 2001-2003 and 2007-2009 while letting you participate in most of the growth, and the model itself in the research paper is back-tested over the past century and would have outperformed S&P 500 while experiencing less volatility:

Source: 1901-2012 Returns: A Quantitative Approach to Tactical Asset Allocation

The problem with the model is it gives many false signals. Since 1995, the model indicated to move away from the S&P 500 a total of 9 times, but 7 out of 9 of those times the S&P 500 quickly went back above its moving average and the model told you to buy again. The other two times it protected from massive losses and more than made up for all those false signals.

In a taxable brokerage account, many of those sales would trigger capital gains taxes, and cost a lot of money. The timing model is therefore not very tax-efficient. But in the TSP, where moving from one fund to another is not a taxable event, the model can work its best.

Sharply reducing exposure to the C Fund and S Fund whenever the S&P 500 drops below its 10-month moving average, and going back into those funds whenever the S&P 500 goes above its 10-month moving average, is evidenced to help you avoid big drops while participating in most of the upside potential.

You can also reduce the number of false signals by adding a valuation criterium to the model. In 2004, 2010, and 2012, the timing model said to sell the S&P 500, but the market was not very highly-valued during those times, and the economy was only a couple years away from its previous market bottom. It would be sensible to ignore the model telling you to sell at those times. In 2018, however, we’re 9 years into the second longest bull market and valuations are the second highest they’ve ever been according to most metrics. If the model says to sell, it may indeed protect against large losses.

The model is not foolproof. It can’t protect against massive sudden market drops, like in 1987 when the S&P 500 fell over 22% on a single day. And investors need to have the discipline to get back into the market when the model says to do so. Plus, it won’t do very well if we encounter a long sideways choppy market without big gains or losses.

Due to the requirement to monitor moving averages and change exposure to various funds, this method is only suitable for investors that understand it well and are willing to take an active approach, and still offers no guarantees. For most investors, the buy-diversify-hold approach is the way to go.

Lyn Alden is a financial writer and an engineer, and holds a bachelor’s in engineering and a master’s in engineering management, with a focus on financial modeling and resource management. She specializes in analyzing and presenting financial data. Her investment work can be found on LynAlden.com.