I am worried about the current uncertainty in the markets.  How should I go about picking conservative investments for my 401(k)?

Sincerely,

Conservative Investor

Dear Conservative Investor,

I have never seen a golfer choose to tee off a hole with their putter. And yet many young investors do start out with a putter by putting all of their retirement investments in a very conservative portfolio. You want to start out with some power and get to the fairway. As you get closer to the hole with each shot (this could be too much of an assumption for those hacks like me), you can focus on precision over power.

Imagine for a moment that you are being paid to move pottery from a warehouse to an adjacent showroom. Those who rush may end up breaking some items; those who move too slowly will risk not meeting their daily and annual quota. To the chagrin of a conservative investor, there is no getting around risks while pursuing financial freedom.

Annual returns will ultimately be determined by the type of portfolio risks you take. Portfolio construction begins with the most basic allocation between investments that offer a greater chance of appreciation (stocks) and those that provide portfolio stability (bonds). For example, younger investors have a longer time horizon to wait out market volatility, which is why professionals typically encourage a larger allocation to stocks. We estimate that an aggressive portfolio that is invested 90% in equities and 10% in bonds  can expect a long term average return of 10.11% (5.61% real return and 4.5% average inflation) and a standard deviation of 15.61%.

It is likely that your 401(k) offers all-in-one asset allocation (often called “target-date”) investment options. These funds take the complexity out of selecting retirement investments by instantly diversifying your investments broadly. But before you settle on this simple solution, make sure you understand the fees involved. Some age-appropriate funds have fees that are significantly higher than all of their component parts, and if this is the case, you will likely be better off creating your own portfolio mix of low-cost funds. The bottom line for all investors is that fees matter, and you are more likely to achieve optimal returns in a low-cost portfolio.

As a benchmark for your 401(k) fees and performance, review the Vanguard Target Retirement Funds. These all-in-one funds have very low costs and well-researched diversification strategies. For example, the Vanguard Target Retirement 2035 Fund (VTTHX) has acquired fund fees and expenses of 0.19%. If your 401(k) plan does not offer a respectable asset allocation fund, start by using the allocation percentages to stocks and bonds from these all-in-one Vanguard funds to create your own.

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