Selecting investments for an IRA, either for a Roth IRA or Traditional IRA, can be intimidating to many people. There are so many advertisements that bombard you on the TV and in magazines touting that their approach is the best.
Also, you may be inclined to think that you first choose where to open your IRA, and then see what investments are available. In actuality, your thinking should be in reverse; the investments you want will determine where you should open an IRA.
For the most part, this discussion applies to investments you will put in either a Roth or Traditional IRA. If you haven’t yet decided if you should open a Roth or a Traditional IRA, read Roth IRA vs Traditional IRA.
Factors Affecting the Type of Investments to Buy in an IRA
Size of Your IRA Account
Is your IRA balance zero and you are just starting to consider making your first contribution to an IRA? Banks don’t have minimum required balances for savings accounts, but they do for CDs. Brokerage firms and Mutual Funds have minimum requirements to open accounts, usually $2,500 per year. You normally don’t have to have the minimum amount all at one time. Most of the companies will accept weekly or monthly deposits as long as you meet the minimum amount by the end of the year.
If you don’t have much money in your IRA, it would be best to start with a Bank or Brokerage savings or money market account to accumulate money. Once you have $5,000 or more, then consider diversifying into mutual funds or individual securities.
When Will You Need To Withdraw Money?
How many years do you have until retirement? Do you have other assets that you can live on for several years in retirement so that you don’t have to touch your IRA? When do you plan to withdraw the money from your Roth?
If you have more than 15 years until you will touch the money, you can and should consider putting the money in more risky investments such as common stocks. If you are closer to retirement, you have less time to absorb any investment losses and may be withdrawing money during a market downturn. So, you should limit most of your investments to CD’s, money market accounts, savings accounts, etc. The less time you have, the safer the investments should be.
What Type of Investor Are You?
This is your biggest decision. The average investor doesn’t like taking a lot risk with their retirement assets.
In 401ks, workers were encouraged for years to put money in stock funds. Then in 2008, the stock market fell drastically and investors lost up to 60% of their money. If these investors kept their money in the stock market, they are almost back to even in 2011. Unfortunately, the average investor took his money out of stocks after the stock market crash occurred. So a lot of money was lost, and investors are now in low yielding money market accounts or GIC funds, watching the stock market rise without them.
If you are young, and can afford to keep yourself from withdrawing your retirement assets to buy a new car, you should be investing in riskier investments that will produce greater returns over many years. But if you really do not have the stomach for riskier investment, and will stay up at night worrying about them, then put your money in bank CDs.
If you are closer to retirement, you may have the emotional stamina to invest mostly in common stocks, but you need to realize that a sharp, extended drop in the market may affect your ability to retire when you want to. You can and should have some equity (stock) investments in your portfolio, but the older you are, the more money that should be in safer investments.
In general, young investors should have 70%-80% of their assets in equity investments, and 20% – 30% in fixed investments. “Cash” investments, such as a bank savings account, of roughly 5% of your assets should be maintained for emergencies, especially if you are using the IRA as your cash emergency fund.
Where to Open Your IRA
Once you have determined which investments you want to make, this will drive the decision of where to open your IRA(s).
- A Bank – if you really can’t bring yourself to take asset risk, then put your IRA contribution in a savings account or CD
- A Mutual Fund Company – If you decide you want some equity and fixed investments, but you don’t know what securities to buy, then you want your contribution to go to one or more mutual funds. Each fund has a particular investment objective. These will include large company stocks, or small company stocks or global stocks, etc. There are then a lot of specialty funds which might invest in various sectors such as automobile companies, or airline companies or financial companies. For the novice, it is simplest and safest to select a fund investing in large company stocks that have broad exposure to the stock market.
- A Brokerage Account – If you want equity investments and believe that you can choose stocks to create a health diversified portfolio, then you need to open an IRA account at a brokerage firm.
- Diversification to reduce risk – Asset allocation is intended to stop investors from “having all their eggs in one basket.” Allocating among different asset classes, that act differently from one another, allows investors to counterbalance losses in one asset class with gains in another asset class.
- Investment portfolio geared to your personal needs – Over the long term, stocks have outperformed bonds and cash investments such as money market funds. However, stocks can have dramatic swings. Younger investors, who don’t need to sell their investments for a long time can allocate a larger share of their portfolio to stocks. Retirees who need income soon for living expenses will allocate more to bonds and money market funds. These investors don’t want to have to sell stocks during a market downturn.
- Stopping emotional risk – Nobody can predict market fluctuations. By implementing an asset allocation strategy, investors can avoid the temptation to sell their stock portion of the portfolio after market slides, or to keep buying stocks when the market has gone way up.
There is no reason that all the above has to either one or the other. You can open a bank IRA for a the CD portion of your money, some mutual fund IRAs for the majority of your money, and a brokerage account to buy some stocks and bonds. The only requirement is that all IRAs together must be within the overall IRA contribution limits. Read Who is Eligible to Open a Roth IRA and Who Should Open a Traditional IRA.
How to Allocate Your Assets
Asset allocation is defined as spreading your money across a number different types of investments — stocks, bonds, CDs, real estate, precious metals, etc.
If you have a bank CD and a mutual fund, you technically have allocated your assets among two investments. Depending upon your level of tolerance for risk discussed above, it is recommended you allocate assets roughly as follows:
Very conservative investor, short time to retirement – 80% bank CD’s, 20% bank savings account
Conservative investor, short time to retirement – 60% bank CD’s, 10% large stock mutual fund, 10% short term bond mutual fund
Aggressive investor, over 15 years to retirement – 40% large company stock mutual fund, 20% small company stock mutual fund, 10% global stock mutual fund, 20% medium term bond fund, 10% money market mutual fund
Very aggressive investor, over 20 years to retirement – same as Aggressive investor, but increase the stock allocation (reduce bond allocation) even more, and diversify the large company stock portion partly into a commodity fund, and more into a global stock fund.
Tax Advantaged Securities
There are certain investments that you do not want to buy in a Traditional or Roth IRA. If you buy a municipal bond, the interest paid by the issuer (maybe your local county or town) is exempt from federal, state and local income taxes. Given this advantage, the issuer can offer these bonds with lower interest rates than other bonds sold in the market, such as corporate bonds. Since a Traditional IRA is going to be totally taxed when you make a withdrawal, you would be taxed on the bond interest, and you still earn the lower interest rate. In your Roth IRA, all withdrawals are tax free, so you get no benefit from a tax exempt municipal bond, but you still get a lower interest rate than you can on corporate bonds. So, don’t buy any tax advantaged investments for your Traditional or Roth IRA (or your 401k ).
Why Asset Allocation?
There are three reasons to use asset allocation in your investment strategy:
Keep it Simple
You should really consider stock and bond investments for the long term so that you keep ahead of inflation. Several large conservative mutual funds and a money market fund are all you need to get good diversified investment returns, while keeping performance tracking and paperwork to a minimum. Read everything you can about the investments and ask a lot of questions when you open your account. If you still don’t understand some aspects of an investment or it just doesn’t sound right, then stay away from the investment and go elsewhere. Simplicity and understanding is the key to any investment.