Why allocate across a variety of funds?

[ryan]

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Hi. I'm new here. Just discovered the site a few weeks ago and am pleased to have found it.

Here's my situation: I've been in the Navy for 9 years and, so, haveat least11 more years until retirement. I'm wondering what the benefit is to diversifying across several funds, especially the S or I funds.

I realize that it makes sense to slowly move savings from high-risk assets (stocks, etc.) to low-risk ones (bonds, CDs, etc.) as you near retirement and will come to depend on the income. But, in the meantime, how much sense does it make to diversify TSP retirement savings across the S and I funds when the C fund has the best history of returns? I realize that the S and C funds' 10-year returnsare actually pretty close, but the I fund has only returned 5.45% in the past 10 years compared to the C fund's 12%.

I understand the value of diversifying, but isn't diversifying across 500 different stocks (e.g. the C fund) plenty of diversification for long-term holdings?

I ask these questions, not to argue against putting money in the I or S funds, but to find out more about why one would do it. Do those of you invested in the I fund believe that non-U.S. equities might out-perform U.S. equities over the next 2 years, 10 years, or longer period of time? Just wondering.

Thanks for any guidance you could offer. I look forward to reading your replies.

~ Ryan S.

BTW, I've been contributing to the TSP for 3-4 years now and have all my contributions allocated to the C fund. Have been pondering splitting this amount up among several funds for some time, but have not been able to find any convincing reason to do so. Hence my post...

 

[tsptalk]

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Welcome Ryan. Good questions.

I do believe over the long term (20 plus years) the small caps have actually done better. My thoughts on this is that each fund has its moments. Early in an economic recovery you'll find small caps do better as interest ratesare dropping. Later on in the recovery smaller companies start feeling the effects of interest rate hikessince they tend to have higher debt than thelarger companies of the S&P 500. We are currently seeing that transer as the C fund has weathered this pullback a little better than the S.

That said, the small caps are more volatile and could see a nice recovery if the market ever rallies. They have done really well the past two years, but for the next year or so, I believe it's the larger stocks' turn.

The I fund should be considered in a buy and hold account. If you are not going to watch your account very closely, youprobably don't want to putmuch more than 15% of your account in the I fund.It can be very volatile. If you plan to time the market at all you have to follow the movement of the dollar carefully when using the I fund. You can make some good money if you play it right.

So if you time the market you can take advantage of the economic cycles by using the funds wisely. If you buy and hold you may want to spread it out so you are not missing the peaks of each fund.

I hope that helps.
Tom

 

[rokid]

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Ryan,

Severalreasons from a somewhat different perspective:

1. In the 90's the C Fund was the best performer. However, in the 80s the I Fund (EAFE) frequently outperformed the S&P 500. Historically, small stocks, the S fund, have provided the best returns. Therefore, if you can predict which fund will perform the best, go with 100% of that fund. However, under the assumption it is impossible to predict the best performing fund, it's prudent to invest your assets across multiple funds.

2. The I and F Funds usually non-correlate with the C & S Funds, i.e. they often move in opposite directions. Therefore, when the C/S Funds are down, the F/I funds are up. This non-correlation effect tends to lower portfolio risk.

3. Using a mean-variance optimizer (based on Markowitz's Nobel prize winning work) and historical data to plot the efficient frontier, a portfolio of:

9% F; 27% C; 13% S; and 51% I yields the same average annual return as 100% C (12.2%) at 2.6% less risk (16% standard deviation vs. 18.6%). Although it is unlikely that anyonewouldrecommend this portfolio allocation, it does demonstrate the power of diversification.

For additional information on this critical subject, see John Bogel's Common Sense on Mutual Funds and Burton Malkiel's A Random Walk Down Wall Street.