Do you lose sleep every time the financial markets decline, or do you view a market correction as an opportunity to invest at a more reasonable price? How you answer this question reveals a lot about whether your TSP investments are suitable for your risk profile.
Creating a TSP portfolio that accurately reflects your risk profile will help you navigate stock market swings and increase the likelihood that you reach your investment goals.
This week we’re discussing the four components that make up your risk profile: time horizon, risk tolerance, risk capacity, and required rate of return.
One of the most important factors to consider when selecting your investments is your time horizon. When do you need the money for your goal? Since we are discussing the TSP, your retirement date will dictate your time horizon.
The reason that time horizon is crucial when selecting your investments is that the closer you get to retirement, the less likely you’ll be able to tolerate large market swings. This, in part, is because if your account value drops significantly, you may not have enough time for your TSP to recover before needing to withdraw funds.
Hence, the general rule is that the closer you get to your retirement date, the more conservative you want your allocation (the mix of stocks, bonds, and cash).
Read more about preparing for retirement in this article.
On the other hand, federal employees early in their careers generally can withstand more market turbulence since they have a longer time horizon and therefore can “buy the dip” or dollar-cost-average and benefit from market declines.
How comfortable are you with taking risks? Do you lose sleep every time your TSP declines in value? If so, you may have a low tolerance for risk.
Having a low tolerance for risk doesn’t necessarily mean you should only invest in the G fund. But it could mean that you should seek the assistance of a qualified financial planner to help you develop an investing strategy that you are comfortable with and understand.
Having a TSP portfolio aligned with your risk tolerance is critical to helping you avoid emotional reactions when the market declines. If your TSP contains too much risk, you’re more likely to react emotionally and make an investment mistake, such as panicking and selling your C fund shares at the bottom of a crash and missing out on the subsequent market recovery.
On the other hand, a portfolio that is too safe runs the risk of not delivering the rate of return necessary for you to reach your retirement goals and exposes your nest egg to the risk of inflation.
Therefore, the goal is to create a TSP portfolio that will deliver the growth necessary for you to reach your retirement goals while understanding and being comfortable with the risk exposure.
How much risk can you afford to take? Say you only require a 1% annual distribution from your TSP in retirement; in this case, you have far more risk capacity than someone who needs a 5% annual distribution.
This relationship between your reliance on your TSP and your risk capacity is straightforward. The more you will depend on your TSP for your retirement income, the lower your risk capacity.
Now, this isn’t to say that those who will have a heavy reliance shouldn’t take risks; as we will discuss next, some federal employees will have a required rate of return that will necessitate more risk exposure.
Required Rate of Return
What TSP balance will you need in retirement? What rate of return will be required to reach this goal? Any investment strategy will consist of tradeoffs between safety and the rate of return.
For instance, while having your entire TSP invested in all stock funds (C, S, and I) will provide a greater expected growth rate, it will also expose your account to a lot of risk and likely large swings during market corrections.
On the opposite end, limiting your investments to cash or bonds (G & F funds) will substantially reduce your investment risk; however, it may not provide the growth needed to reach your retirement goals.
Thus, when creating your TSP allocation, you’ll have to balance your need for investment growth with the other components of your risk profile.
To learn more about each TSP fund, read this article.
Once your risk profile has been determined, you’re ready to select your asset allocation (mix of stocks, bonds, and cash) for your TSP. When choosing the combination of funds, the general rule is that the more willing and able you are to take on risk, the more you can allocate to stocks.
Investing comes with inherent risk; however, by taking the time to understand your time horizon, risk tolerance, risk capacity, and required rate of return, you’ll invest more confidently, knowing your TSP is tailored for you.
Although I highly recommend working with a fee-only Certified Financial Planner™ to create an investment strategy aligned with your risk profile, if you decide to go it alone, ensure that your risk profile drives your TSP allocation.
Once your TSP is aligned with your risk profile, stick to your plan, and never let emotions drive your investment decisions.
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