Here’s How to Choose the Investments That Make Up Your IRA
The holidays are over and maybe you even wound up with some extra cash. Good for you! But what to do with it? If you have a solid emergency fund (like one of our best financial advisers recommends), then it’s time to set money aside for your IRA. The earlier you start investing, the more time your money has to grow. Often, we make good choices because we care a lot about our own wellbeing, but we can also help you find a financial adviser to fit your needs.
After all, thanks to the power of compounding interest, $300 today can turn into $80,000 by retirement! (We calculated that number here.)
Once you’ve decided to invest in your IRA, the next step is taking a look at how to invest. Since an IRA is an investment account, you need to choose investments.
Here’s our advice:
No Time or Motivation to Stress Out About Your Portfolio?
Consider something called a lifecycle fund, otherwise known as a target-date fund, which automatically reconfigures the items that make up your portfolio (for example, more risky tech stocks if you’re younger, more safe bonds if you’re older) to be best-suited for every stage of your life. Think of it as autopilot for your investments.
More Willing to Dive in? Here’s What You Need to Know
The most important thing is asset allocation, which is the mix of stocks, bonds, and other investments in your portfolio. Believe it or not, your mix of investments is actually more important than any of the actual investments in it. You want a mix of things that are both risky (and, as a result, can offer high rewards) and conservative (so you won’t lose all your money). Most financial advisers recommend taking on riskier investments when you’re younger, since you have more time to make back the money if you lose it. Likewise, you should take on more conservative investments when you’re closer to retirement, since at that point you’re more focused on holding on to what you have already made. Typically, a person’s portfolio should be about 10% bonds when she is below age 35. It should be around 20% at age 40, and close to 40% in her later 50s.
Bonds tend to be safer, more conservative investments than stocks, but they have lower returns than stocks because they’re so safe. A bond works a bit differently than a stock (which represents a share of ownership in an asset). A bond, however, is basically a loan that you give to the government, company, or other institution that issues it. In exchange, they issuer promises to pay you a set amount of interest on top of repaying the loan. When companies go down, the bond owners are much better off the stock holders. Given that, the risk is minimized, and so is the return.
What to Do Now?
If you decide that the low-maintenance lifecycle fund is best for you, then go for it. If you’d rather take a more active role, go for that, too. But, we do not recommend playing your luck by picking individual stocks or bonds. Instead, we recommend buying shares in a type of mutual fund (a pool of money that invests in a collection of assets, such as stocks or bonds, in order to minimize your risk by investing in many things rather than just one) called an index fund. An index funds is comprised of a group of securities designed to mimic the returns of a market index such as the S&P 500.
When you’re choosing a mutual fund, pay attention to the “expense ratio,” which covers the fund’s operating costs. (Stock index funds tend to have lower expense ratios since the manager is only focused on mimicking the index.) According to Morningstar, a leader in investment research in North America: “As a general rule of thumb, you shouldn’t pay more than 0.75% for a bond fund and 1.0% for a core equity fund.”
In addition to the expense ratio, some mutual funds may charge a “front load” (a fee when you put your money in), a “back load” (a fee when you take money out), or a “constant load” (fees that are taken out regularly). We recommend that you ONLY invest in NO-LOAD funds. Check out Morningstar’s Fund Screener to find funds with good expense ratios and minimum deposits that are within your budget.
You might want to choose a few index funds that cover different areas like domestic stocks, international stocks, real estate investment trusts, and treasury bonds. Again, Morningstar’s Fund Screener can help you to find funds that meet your specifications.
Once you’re all set, go for it! Don’t be afraid of being too risky at this stage of the game. If you’re in your twenties, the biggest risk is not investing in the first place.
Take a deep breath. Now, make a note on your calendar to rebalance your portfolio a year from now. If you don’t know what that is, go take a breather. We’ll dive into that later.