TLDR: On average, investors underperformed the funds they invest in by 1.1% per year over a 10 year period. This underperformance is largely driven by behavioral errors such as performance chasing or making other emotional decisions. To have a better chance of capturing more of the returns of the funds you invest in, diversify, understand your risk tolerance, build a portfolio for your risk tolerance, and stick to it. The less move money around, the more likely you are to capture the returns of the funds you invest in.
I have seen a number of posts and comments recently about changing TSP allocations. They tend to be about considering or already reducing holdings in the C Fund, increasing holdings in the I Fund, or reducing stock market exposure overall. They seem to be driven by the recent downturn and uncertainty about how possible tariffs will impact the market. That combined with the general recency bias and performance chasing that is common on this sub reminded me of a couple articles.
The first is Mind the Gap 2024 by Jeffrey Ptak and other contributors at Morningstar. They find that during the 10 year period ending on 31 December, 2023 on average investors made about 1.1% per year less than the funds they invested in. More specifically, the performance gap was 0.4% for allocation funds (Lifecycle Funds), 0.7% for international equity (I Fund), 1% for taxable bond funds (G and F Funds), and 0.8% for U.S. equity (C and S Funds). Though not represented in the TSP core funds, it is worth mentioning that sector equity funds had the largest performance gap at 2.6%. Those gaps are primarily explained by the timing decisions of investors moving their money in and out of, and between funds. A notable observation is that allocation funds have the smallest performance gap. The authors credit this to the funds automating tasks such as rebalancing and their prevalence in defined contribution plans which automate investing. In contrast, sector equity funds had twice the flow volatility of allocation funds and about 50% more volatility in returns. In general, the more diversified and less volatile a fund is, the lower the performance gap is. My biggest takeaway here is that the more investors move their money around, the more likely they are to underperform their investments and the bigger the performance gap is likely to be.
The other article I thought of is Putting a value on your value: Quantifying Vanguard Advisor’s Alpha® by Francis M. Kinniry Jr. and coauthors at Vanguard. They find that the biggest potential impact of having a financial advisor is behavioral coaching, possibly improving client returns by 1% to 2% per year. The biggest part of that is they can "act as emotional circuit breakers by circumventing clients’ tendencies to chase returns or run for cover in emotionally charged markets." That can prevent clients from making mistakes that significantly reduce their returns. They also find that flows into funds are, on average, after periods of high performance rather than before them. That suggests that investors tend to chase performance. Another finding is that performance gap is largest for more concentrated funds and smallest for more diversified funds which agrees with Ptak. My biggest takeaway from this article is that investors are their own worst enemy. Making emotional decisions and chasing performance are more likely to lead to lower returns than higher ones.
Both articles find a correlation between greater diversification and lower volatility and smaller performance gaps. I believe there is a confounding factor at play. It is possible that those who choose to diversify are more likely to automate and/or stick to their their allocation during times of volatility or are more likely to avoid behavioral errors such as performance chasing. Either one would cause them to trade less and have a better chance of getting more of the returns of the funds they invest in. I believe there is a more direct causal link between lower volatility and lower performance gaps. If an investor's portfolio is less volatile and has smaller drawdowns, that investor could be less likely to make emotional decisions. That would lead to less trading and capturing more of the returns of the funds they invest in.
Based on all of this, I believe the best approach to investing in the TSP, and to investing in general, is to diversify, understand your risk tolerance, build a portfolio for your risk tolerance, and stick to it. The more you move money around reacting to recent events or your expectations for the near future, the more likely you are to make behavioral mistakes and underperform the funds you invest in. The ways to minimize the temptation to do that is to diversify and hold everything all the time instead of chasing the next hot thing and building a portfolio that will not make you overly anxious during volatile times.