One of the best things about an IRA is the ability to pick from a large selection of investment options. Most traditional and Roth IRA providers allow you to invest in individual stocks or choose from a long list of mutual funds, for example. Here’s a step-by-step process for how to invest your IRA.
1. Understand asset allocation
Asset allocation is how your money is divided among different types of investments. Big picture, that means stocks, bonds and cash; little picture, it gets into specifics like large-cap stocks versus small-cap stocks, corporate bonds versus municipal bonds, and so on.
For example, if you have a $10,000 IRA to invest and you choose to put $6,000 into stock funds and $4,000 into bond funds, your asset allocation is 60/40.
Asset allocation has a big influence on returns because different asset classes carry different amounts of risk and potential returns.
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2. Think about your tolerance for risk
This involves considering your time horizon (how long the money will be invested) and your ability to tolerate risk. You want to take enough risk that your money will grow, but not so much that you’ll bail out or lose all your hair when the market gets rocky.
One rough method of calculating your risk tolerance is to subtract your age from 100 (or, to sway more toward risk, 110). The result is the percentage of your portfolio that you would allocate toward stocks. For example, a 30-year-old investor would direct 70% to 80% of their portfolio to stocks.
- You may want more or less equity exposure than the guide dictates, so it’s fine to use it as a starting point and then edge the numbers around until they suit your needs (an investment calculator can help with estimating returns over time).
- Your age matters. In general, you want to take more risk when you’re young and then taper down as you inch toward retirement.
- That doesn’t mean you shouldn’t invest in stocks in retirement — given today’s life spans, you’ll still need that money to last several decades past age 67, and that requires investment growth — but many people choose to dial it back a bit to preserve their capital and so that there’s a greater fixed-income allocation from which to take distributions. That way, if the market takes a dive, you don’t have to sell at a low; you can simply pull from the safer havens in your portfolio.
3. Consider mutual funds
There are many strategies you can use to build a portfolio, but here we will focus on two. Filling your IRA with individual stocks and bonds is one option. Another is to use mutual funds or exchange-traded funds (ETFs) for better diversification and, over the long term, potentially better results.
Building a portfolio with stocks and bonds
You might be tempted to build your IRA around individual stocks and bonds, but this is rarely the best approach for anyone but a professional investor. It is virtually a full-time job, requiring extensive research, planning and attention to your portfolio.
Diversification through index funds and ETFs
Through index funds and ETFs, you’re buying a basket of investments rather than the stock of just one company: An S&P 500 index fund, for instance, invests in some of the largest U.S. companies.
Many investors allocate more of the equity portion of their portfolios to the biggest asset classes — for example, a large-cap fund or a total stock market fund, and secondarily, a developed markets or international stock fund — and less to smaller classes, such as small- and mid-cap funds or emerging markets. They might put most of their bond allocations into a total U.S. bond market fund and less into an international bond fund.
You can find index funds and ETFs that meet your asset allocation goals with the help of a fund screener. This is a tool many online brokers and websites offer; it can help you sort funds by expense ratio, type, performance and other factors.
4. Know when to leave it to the pros
Managing an IRA alone can work well for many investors, but at times, bringing in outside help can be useful. Maybe you want a personalized strategy, especially if your financial situation is growing more complex, and you want to be able to ask questions to a human advisor that stays up to date with your goals.
In these instances, consider bringing on a financial advisor who can help you make informed decisions about your IRA and how it fits into the rest of your financial planning. When researching financial advisors, also be sure to ask about fees, so you know how they get paid and whether that fits with your budget.
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