Do you expect your TSP account to go up?
“Of course! Why else would I be investing in the TSP?!” This is the reply I get when I ask this question in my classes. This seems to be an easy question to answer.
But then I ask another easy question… Do you expect your TSP account to go DOWN?
This is the exact opposite of the first question. So, if you quickly replied “of course!” to the first question, seemingly you would quickly reply “of course NOT!” to this question.
But for some reason this question is not so quickly answered. Many people start asking me “what do I mean “go down?” or they say “we don’t expect it, but we know there are UPS and DOWNS.”
Why is this question harder to answer than the first? I think it’s because investors confuse two terms. Many investors have the HOPE that their investments go UP. But HOPE and EXPECT are VERY DIFFERENT. When I play lotto, I HOPE to win, but I EXPECT to lose.
When you invest your money, you hope it goes up but what do you EXPECT it to do? What is your expectation? Before you read on, please jot down your answer.
Okay now please answer WHY do you expect that (assuming you even had a defined expectation)?
Do you expect it to go up by 5%? 10%? Why?
Do you expect it to go down 5%? 10%? Why?
If you cannot answer these questions, you have plenty of company. But that doesn’t make you feel more confident in your investments, does it?
Not having an expectation of what your TSP will do is a MAJOR mistake for a number of reasons. Here are two:
- In order to justify taking risk, you need to have some expectation of reward: This idea was touched upon in an earlier mistake. You may have low-risk or even no-risk vehicles that are providing you with reward. The example we gave of a no-risk vehicle was that of your debt. As we noted there, paying off debt provides a quantifiable rate of return, that is guaranteed! (The rate of return you earn on your debt is the interest rate that you avoided. If you have debt that charges you 10%, by avoiding that interest charge you got yourself a 10% rate of return. If you have debt that charges you 19.99%, by avoiding that interest charge you got yourself a 19.99% rate of return. If you have debt that charges you only 3%, by avoiding that interest charge you got yourself a 3% rate of return.) Whatever guaranteed rate of return you could get on your debt needs to be compared to the non-guaranteed rate of return you’d be getting with your TSP investments. What is the non-guaranteed return that you expect in your TSP and does it justify taking the risks and leaving behind the no-risk reward of your debt?
- The rewards of a risky investment usually require you to be able to stomach the risk: This is classic risk tolerance. Your investments may yield solid returns but those returns usually come with a wild roller-coaster ride. Studies have clearly shown that investors often get scared out of their investments when the investment shows signs of decline, only to remain out of those investments as they experience their greatest growth spurts. If you don’t know what kind of fluctuations to EXPECT in your investments, you may be getting onto a roller coaster ride which will end up costing you dearly.
So, it’s important to know what to expect from your TSP. But how do you do it? How can you establish a reasonable expectation of your TSP performance? An analogy to illustrate: Imagine you were looking to hire an employee who possesses the following character traits:
You have before you two candidates applying for this position. Candidate ‘A’ possesses all of those traits and has references testifying those traits date back to early childhood. Candidate ‘B’ possesses NONE of those traits.
Which candidate would you hire?
Candidate ‘A’ is the obvious choice. Why? Maybe Candidate ‘A’ will have a sudden character change and lose all those fine traits? Isn’t that possible? It is POSSIBLE, but I have a strong reason to believe candidate ‘A’ will continue to behave in the way they’ve behaved for many years. I EXPECT candidate ‘A’ to continue their PAST PERFORMANCE.
The above illustration compared someone with a past performance to someone with NO past performance. But let’s take the thought a step further. Let’s say that Candidate ‘B’ also has SOME positive past performance. In fact, ‘B’ has character references that testify that ‘B’ has had such fine qualities for 2 years! Okay, not bad, right?
But ‘A’ has demonstrated these traits for 20 years.
Who would you hire?
Presumably, you’d hire ‘A’ because they’ve demonstrated the behaviors you seek more consistently than ‘B’, thus giving you more grounds to EXPECT that mode of conduct. Granted ‘A’ can change, and ‘B’ may improve, all that is POSSIBLE. But CONSISTENT PAST PERFORMANCE sets a STANDARD of EXPECTED BEHAVIOR. The more often we see a pattern of behavior, the more we can ASSUME that behavior is STANDARD BEHAVIOR.
Once we establish a standard, we don’t just HOPE that behavior will continue, but rather we EXPECT that behavior to continue.
So what is the standard behavior of your investments?
This is where the science of investing begins. Each one of funds in the TSP has a STANDARD BEHAVIOR! This is a metric that is studied closely by asset managers including the managers of your TSP. It is called the STANDARD DEVIATION.
How Standard Deviation (STD) works:
Each year, the TSP funds perform as they do. They go up or down (or stay flat). After each year we measure that up or down and state the change in percentages (eg. The C-Fund went up by 16.07% in 2012). We then take that 1-year performance and factor that into the total historic 1-year performances for the Fund. So if the C-Fund has a 26-year history (since 1988), we can add all the 1-year performances together and divide by 26 and we’d find the average 1-year performance – which happens to be 9.25%.
After we figure out the 1-year averages we can then investigate how often the fund performs exactly at the average. And guess what? The fund almost NEVER performs at its average!
That’s just the nature of averages. The fund always outperforms or under-performs the average. So we should never really EXPECT a fund to perform its average. It always DEVIATES from the average. But when it does deviate, how far off the average does it typically deviate? This is expressed as a standard deviation (STD). Scientifically, close to 70% of an investment’s behavior is represented in 1STD, thus making 1STD the EXPECTED range of behavior for an investment.
Thankfully, you don’t need to calculate the STD of the TSP funds. The TSP has done it for you and has it published on the TSP website and fund sheets.
The purpose of this long explanation is to show you that you can and NEED to set expectations of your investment’s behavior. Not doing so is a mistake that will prevent you from maximizing your TSP (and your other investments).