Using the Efficient Frontier to Maximize TSP Returns

Disclaimer: Past performance does not guarantee future results! However, analyzing past data is often the best tool we have to make educated decisions on how to invest for the future. The methodology I present here is essentially just this - an analysis of past performance to help inform investment decision making today.

The Efficient Frontier

First things first - what is the "efficient frontier"?

Each available investment asset - individual stocks, ETFs, mutual funds, etc. - has a given level of risk and return (calculated based on past performance). These assets can be combined to diversify your portfolio and maximize the expected return at a given risk level. The efficient frontier is just the set of portfolios which provide the maximum return at each level of risk. 

Just looking at the chart above, you can see that you would obviously want to select one of the green (efficient) portfolios over the red (inefficient) portfolios which fall below it. The reason this works has to do with correlation and covariance between assets that make up a portfolio. This is a more complicated topic which I may address in detail in a future post, but the idea is that some assets move with each other (positive correlation), and some move opposite of each other (negative correlation). You can use this to your advantage to dial in a portfolio which maximizes the expected return at the risk level you can tolerate.

TSP Funds and the Efficient Frontier

I took the performance data for all of the available TSP funds over the past 10 years and calculated the risk and return for about 3,000 portfolio combinations. Each blue dot on the chart below is one of these combinations. You can also see where each individual fund falls (including the life cycle funds). The green line is the approximate efficient frontier.  

You'll notice that the bottom left end of the curve doesn't look quite like the generic example above. This is because of the G Fund, which is unique to the TSP. The G fund is a nearly zero-risk investment which is subsidized by the U.S. government and isn't available to outside investors.

Also note that all of the life cycle funds fall well below the efficient frontier. This means that over the past 10 years, the life cycle funds were far from the best choice from a risk/return standpoint. 

So What Can I Do With This?

The obvious next question is - how do I apply this to my TSP investment strategy? Keeping in mind the disclaimer about past performance and future results, I will present to you how I have used this analysis in an attempt to pick a TSP portfolio which maximizes expected return at my desired risk level.

Of course I have all of this analysis built into an Excel spreadsheet with lots of variables I can modify. Most critically, I set my desired risk level (bench-marked to the other funds). Then the solver finds the portfolio with the maximum expected return at that risk level. 

My current mix (bench-marked to the 2040 life-cycle fund risk level and with a minimum constraint of at least 5% in each fund):

• G Fund: 5% (set by minimum constraint)
• F Fund: 5% (set by minimum constraint)
• C Fund: 62%
• S Fund: 23%
• I Fund: 5% (set by minimum constraint)

If you are interested in seeing a specific scenario analyzed/solved, please comment below and I'd be happy to run it through my analysis and provide the results.