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One of the best things about an IRA — compared with, say, a workplace retirement plan like a 401(k) — is the much larger selection of investment options available within the account.
In most IRA accounts, you can pick individual stocks or choose from a long list of mutual funds. Or you can leave those decisions to an expert by choosing a low-cost robo-advisor — a computer-powered investment manager — to do the work for you. (Check out our top picks for robo-advisors.)
That breadth of choice makes the IRA — both Roth and traditional IRAs — an attractive option for your retirement savings, especially once you’ve maxed out 401(k) matching dollars. But in some ways, choice also makes things more difficult for the investor.
Here’s a step-by-step process for how to choose investments for your IRA.
1. Understand asset allocation
Just the words “asset allocation” sound complicated, but they’re not: This is simply 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.
If you invest $10,000 in an IRA account and $6,000 of it is in stock funds and $4,000 of it is in bond funds, your asset allocation is 60/40. Keep in mind: You’ll get the biggest return over time — and take the greatest amount of risk — with stocks (also known as equities), while bonds and other fixed-income investments help balance out that risk because they’re relatively safe compared with stocks.
2. Consider your tolerance for risk
This is the trick of it all, and it involves considering a couple of things, including 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.
How to calculate risk tolerance
There are rules of thumb to guide you, the most notable being to subtract your age from 100 (or, to sway more toward risk, 110). The resulting number is the percentage of your portfolio that should be allocated toward stocks: Under this rule, if you’re 30, you’d direct 70% to 80% that way. You may find you want more or less equity exposure than the rule dictates, so it’s fine to use it as a starting point and then edge the numbers around until they suit your needs.
Your age matters because, 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 30 or more years past age 67, and that requires investment growth — but many people choose to dial it back a bit so 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.
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3. Use mutual funds for the base of your portfolio
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 compose your portfolio of mutual funds or exchange-traded funds (ETFs) for better diversification and, over the long term, better results.
Diversification through index funds and ETFs
Index funds and ETFs are among our favorite investment options. Through one of these funds, 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; it’s classified as a “large-cap” fund for that reason (“cap,” short for "capitalization," refers to the valuation of the companies).
In most cases, you’ll want to allocate more of the equity portion of your portfolio to the biggest asset classes — for example, that large-cap fund or a total stock market fund, and secondarily, a developed markets or international stock fund — and less to smaller classes, like small- and mid-cap funds and emerging markets. You might put most of your bond allocation into a total U.S. bond market fund, and a lesser amount into an international bond fund.
Choose index funds and ETFs to meet your asset allocation, with the help of a fund screener. This is a tool offered by many online brokers (as well as sites like Yahoo and Morningstar) that can help you sort by expense ratio, fund type, performance and other factors.
Building a portfolio with stocks and bonds
You might be tempted to fill your IRA with individual stocks and bonds, but this is rarely the best approach for anyone but a professional investor. If you’re a real go-getter, you can forget funds and build that portfolio of individual stocks and bonds. But this is virtually a full-time job, requiring extensive research, planning and attention to your portfolio. Still, if you’re willing and able to put in the time, it may pay off. (If you’re unsure, allocate a small percentage of your portfolio to stock trading to test the waters; here are our tips for trading stocks.)
4. Know when to leave it to the pros
If you don’t have any interest in selecting investments, you might want to outsource this to a professional. There are two ways to get what amounts to low-cost portfolio management: target-date funds and robo-advisors.
Target Date Fund
A target-date fund is a mutual fund designed to work toward the year its investors plan to retire; because of that, the funds are named by year: If you plan to retire around 2050, you’d select a target-date fund with 2050 in its title.
It will then do all of the work for you, rebalancing as needed and taking an appropriate amount of risk as you age. These funds are very popular in 401(k)s and tend to have higher expense ratios, but through an IRA you can shop a wider selection to find a low-cost option. You don’t need to diversify among target-date funds — you put all of your IRA money into the single fund.
To use a robo-advisor, you would need to open an IRA account at one of these companies, like Betterment or Wealthfront. The company would then build and manage an ETF portfolio for you, based on your age, risk tolerance and other factors — most services have you fill out an initial questionnaire — for an annual management fee of around 0.25%.
No matter what you do, take steps to minimize all types of investment fees. Left unchecked, these expenses can quickly start to swallow your portfolio’s returns. Make sure your IRA offers competitive commissions and abundant low-cost investment options.
For more, check out our analysis of the best IRA providers.