Why the Thrift Savings Plan Has Plenty of Diversification for Any Investor

This article first appeared as a guest post on Ryan Guina’s Military Wallet.

Many people dislike the Thrift Savings Plan (TSP) because they feel it isn’t sufficiently diversified. This is an easy point to make, since TSP has five investment funds, if you don’t include the Lifecycle funds, which are target-date funds (or funds of funds). However, this article will illustrate that TSP is sufficiently diversified for just about any portfolio. In doing so, this article will only provide a basic level of understanding to everyday investors, not to explain complicated investment theories.

What is diversification? It might be worthwhile to explain diversification itself, and its role in reducing total risk. According to Investopedia, diversification attempts to ‘smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others.’ So why is the term ‘unsystematic risk’ underlined? It’s important to know what role unsystematic risk (also known as diversifiable risk) plays in investing. Below are a couple more definitions:

• Unsystematic risk: Company or industry-specific hazard inherent to each investment.
• Systematic risk: The risk inherent to the entire market or an entire market segment. Also known as beta
• Total risk: Unsystematic risk + systematic risk

In other words, diversification will only reduce the impact that one stock’s performance has on the market as a whole. It does not reduce the inherent risk that exists when you put your money in the overall market. Let’s look at two examples:

Investor A has a $10,000 portfolio that consists of 10 stocks, each valued at $1000. Investor B has a $10,000 portfolio, with 100 stocks, each valued at $100. A year later, let’s say that in each portfolio, all the stocks went up by 10%, except for one company in each portfolio that went bankrupt, and their stock became worthless. That means that each Portfolio A winner is now $1100, and each Portfolio B winner is now $110.  Here’s how each portfolio would look:

Portfolio A:    9 X (1100) + 1 X (0) = $9,900

Portfolio B:   99 X (110) + 1 X (0) = $10,890

You can see that Portfolio A’s bankrupt company caused the overall return to be -1%, while Portfolio B still eked out a 8.9% gain. That is the power of diversification-one company’s bad performance is compensated by the good performance of more companies in the portfolio. However, if we enter a global recession, or a terrorist attack happens & the overall market goes down, that overall effect will generally occur regardless of how diversified your portfolio is.  That is known as systematic risk.

What constitutes sufficient diversification?

There is much research on the topic of diversification.  Specifically, there is a lot of research on how many different investments a portfolio should have before it’s considered to be sufficiently diversified. However, the impact of a single stock on a portfolio of randomly selected stocks goes down significantly after you reach 30 stocks, and becomes statistically insignificant beyond 1,000.  Without going into much detail, let’s assume that 1,000 is a safe number to use as a basis for comparison.

What does TSP invest in?

TSP funds come in 5 different funds: G, F, C, S, & I funds. Let’s look at how many securities are in each fund, according to their information sheets.

G Fund: G fund’s rate is calculated by the U.S. Treasury as the weighted average yield of approximately 125 US government securities on the last day of the previous month.

F Fund: Index fund that tracks the Barclays Capital U.S. Aggregate Bond Index. As of TSP’s last report, this index had 9,079 different government, corporate & non-corporate bonds and asset-backed securities.

C Fund: Index fund that tracks the S&P 500 Index.  By definition, the S&P 500 contains securities from the 500 largest U.S. companies.

S Fund: Index fund that tracks the Dow Jones U.S. Completion Total Stock Market Index, which includes all of the actively traded U.S. stocks not in the S&P 500. As of TSP’s last report, this index contained 3,274 common stocks.

I Fund: Index fund that tracks the Morgan Stanley Capital International EAFE (Europe, Australasia, & Far East) Index. As of MSCI’s last report, this index contained the stocks of 926 different companies located in 21 countries.

How does TSP meet the broader definition of diversification?

If you count all the different investments, you get 13,904 different securities. Furthermore, these securities are diversified in terms of market capitalization (company size), industry, sector, country, and type of investment (stocks vs. bonds). However, there are a couple of areas that are not represented in TSP:

• No Africa companies, as the EAFE does not follow markets in Africa. There are few African securities markets that are effectively regulated or provide liquid (easily marketable) investments.
• No investments in master-limited partnerships or non-traded securities. Again, being able to easily buy & sell investments at a price close to their value is an important aspect.
• No investments in options, commodities (such as precious metals or oil) or futures. Highly speculative markets.
• No investments in speculative (a.k.a. junk) bonds. F fund only tracks investment-grade bonds.
• No investments in preferred stocks.
• No investments in mortgage-backed securities, credit default swaps and collateralized debt obligations. If you don’t understand any of these terms, these are the investments that led to the mortgage crisis and the 2008 recession. Turns out most of the bankers didn’t understand them either.

All of these investments have one thing in common—if you’re an average investor, you probably shouldn’t be in them. In fact, most professional investors don’t touch many of these investments.

The Bottom Line

You could argue that there are still some safe investments that are not available in TSP. However, you will probably find that staying in the TSP family of funds will provide enough diversification for most portfolios. In fact, unless you are an expert investor, your next investment outside of TSP will probably end up repeating some of the securities already in TSP. The difference is, you’ll pay more for that transaction, through either trade commissions or higher management fees, than you would by staying within TSP.

As always, this blog serves to answer your questions and address concerns.  If you like this blog, please forward it on to other people who may benefit.  If you have issues or concerns, or if you have a question you’d like me to answer, please feel free to contact me.  You can reach me through my website, or via email.  In the meanwhile, take charge of your life!