Why TSP Has Enough Diversification for Any Investor (Unless Investing is Your Hobby)

Diversification is one of the most important attributes of a solid investment strategy.  Many people dislike the Thrift Savings Plan (TSP) because they feel it doesn’t have enough diversification. This is an easy point to make, since TSP has only five investment funds, not counting the lifecycle funds, which are target-date funds (or, more accurately, funds of funds).

However, this article shows that TSP offers sufficient diversification for just about any portfolio (unless, of course, investing is your hobby and you’re constantly trying to find different places to put your money). That said, this article provides a basic understanding for everyday investors, not an explanation of complicated investment theories.

What is Diversification?

Before we discuss TSP, 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” emphasized? 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 that is inherent in each investment
• Systematic risk: The risk inherent to the entire market or an entire market segment
• Total risk: Unsystematic risk + systematic risk

In other words, diversification reduces the impact of one stock’s performance on the market as a whole. It does not reduce the inherent risk of investing in the overall market.

Let’s look at two examples:

Investor A has a $1,000 portfolio that consists of 10 stocks, each valued at $100. Investor B has a $1,000 portfolio, with 100 stocks, each valued at $10. A year later, let’s say that, in each portfolio, all the stocks went up by 10%, except for one company that went bankrupt, and the stock became worthless. That means that each Portfolio A winner is now $110, and each Portfolio B winner is now $11. Here’s how each portfolio would look:

• Portfolio A: 9 X (110) + 1 X (0) = $990
• Portfolio B:   99 X (11) + 1 X (0) = $1,089

You can see that Portfolio A’s bankrupt company caused the overall return to be -1%, while Portfolio B still managed an 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 a terrorist event occurs or we enter a global recession and the overall market goes down, that overall effect (known as systematic risk) will generally happen regardless of how diversified your portfolio is.

What Constitutes Sufficient Diversification?

Much research examines diversification, specifically how many different investments a portfolio needs to be sufficiently diversified. However, a single stock’s impact on a randomly selected portfolio drops significantly after 30 stocks and becomes statistically insignificant beyond 1000 stocks.

What are TSP’s Investments?

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

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

F Fund: Index fund that tracks the Bloomberg U.S. Aggregate Bond Index. As of TSP’s last report, this index included more than 13,600 government, corporate, and non-corporate bonds and asset-backed securities.

C Fund: Index fund that tracks the S&P 500 Index, which, by definition, 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 3,741 common stocks.

I Fund: Index fund that tracks the MSCI ACWI IMI ex USA ex China ex Hong Kong Index. As of TSP’s last report, this index tracked stocks of 5,306 companies in 44 countries.

How Does TSP Meet the Broader Definition of Diversification?

If you count all the different investments, you get over 23,000 different securities. Furthermore, these securities are diversified in terms of market capitalization (company size), industry, sector and type of investment (stocks versus bonds). There are a couple of shortfalls:

• No investments in master-limited partnerships or non-traded securities. Again, being able to buy and sell investments easily at a price close to their value matters.
• No investments in options, commodities (such as precious metals or oil) or futures. These are highly speculative markets.
• No investments in speculative (a.k.a. junk) bonds. The F fund only tracks investment-grade bonds.
• No investments in preferred stocks.
• No investments in mortgage-backed securities, credit default swaps or 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 make them, either.

You could argue that some safe investments aren’t available in the TSP. However, you will probably find that staying in the TSP portfolio will provide enough investment options for most people. In fact, unless you are an expert investor, your next investment outside of TSP will probably repeat some of the securities already in TSP. The difference is that you’ll pay more for that transaction, through either trade commissions or higher management fees, than you would by staying within TSP.

Meet the Author

Forrest Baumhover

Forrest Baumhover is a Certified Financial Planner™ and enrolled agent. As a retired naval officer, Forrest helps veterans, transitioning service members and their families address the financial...

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