What's your risk tolerance?
Before plunging into investments, gaze deep into your soul and ask, "How will I feel when my account balance falls by 40%?"
Very generally, having more stocks than bonds means many exciting days of having no idea how much your account could be worth. But you shouldn't be checking your balance every day anyway.
A portfolio full of stocks, or stock mutual funds, is likely to go up over time faster than a portfolio filled with bonds. But in the short term, the value will move around much more. Bonds are less volatile than stocks and generally have a fixed rate of return. But expect the return on bonds to be lower than that of stocks over time.
So the first rule of IRA investing for beginners is to toughen up. Thicken your skin. Ignore the market gyrations. Even though there may be periods of extreme volatility, the trend over long time periods is up, up and away.
Asset allocation and time horizon
Essentially, when pondering the investing options, the first question to answer is, "How much stock do I need?"
Your time horizon should influence how much risk you're willing to take. When do you plan to retire?
"If you have 5 years or more until you need the money, that would suggest a portfolio with higher return and more volatility. If you are closer to retirement -- in less than 5 years -- asset protection might be a higher priority, and a higher weighting to more conservative asset classes may make more sense," says John Bradberry, CFP professional with Greystone Financial Group, an office of MetLife in Roanoke, Virginia.
The basic rule of thumb is that most people with a couple of decades or more until retirement can afford to take on lots of risk. That means putting most of your money into stocks or, more likely, stock mutual funds or exchange-traded funds.
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Why you simply must buy stocks
Stocks are vital to long-term success. Without the oomph provided by compounding stock-market returns, a saver would need to put away much more money to reach his or her retirement goals.
Compounding is the process by which savings and investments grow: Interest is added to principal and it starts to earn interest. Little bits of interest pack onto the initial savings until it doubles and then triples over time like a snowball rolling down a hill.
Risk-averse investors may want to seriously study the art of investing to feel more confident about their decisions, or simply hire a professional for guidance.
"If you are a beginning investor, your time horizon to retirement is likely very long, over 20 or 30 years for most folks. With that kind of time horizon, you want to allocate your assets into stocks, as stocks earn more than bonds over the long run," says Robert Johnson, CFA, president and CEO of The American College of Financial Services in Bryn Mawr, Pennsylvania.
"In fact, since 1926, large-capitalization stocks have, on average, advanced by 10% compounded annually," he says.
Large-cap stocks are the behemoths of the business world -- all of the biggest companies on the planet. Think Apple, Exxon Mobile, IBM and General Electric. They are tracked by a well-known index fund called the Standard & Poor's 500 index.
But which stocks or funds to buy?
It seems as if there are as many mutual funds as there are stars in the galaxy. The number of choices can be daunting, particularly for beginner IRA investors. Luckily, there's an easy solution.
"A beginner should simply pick a low-cost, large-capitalization equity fund like the Vanguard 500 Index Fund. It has annual fees that are among the lowest of any fund," Johnson says.
An investor could do worse than picking a solid index fund such as one that tracks the S&P 500, says Eric Meermann, CFP professional and portfolio manager with Palisades Hudson Financial Group in Scarsdale, New York.
"For an initial contribution, buying a diversified, low-cost mutual fund that tracks an index is a good bet. Diversified investing, holding positions for the long term, and not trying to time the markets is the best advice for both IRA beginners and those with substantial wealth," he says.
Large-cap stocks tend to be less volatile than smaller companies. As time goes on, a beginning investor could build out their asset allocation plan with index funds representing small- and mid-cap companies in addition to an international index fund.
Or, they could do something entirely different. The important thing is to have a plan and save consistently and invest systematically. This is merely a starting point.
Don't stress, but do invest
Getting cash into the account before the April deadline is only part of the battle. Putting the money to work as soon as possible is the real goal.
Investors without a plan often make contributions to their IRA on time, but then they leave the contribution un-invested for some time, a study by Vanguard found.
The mutual fund giant looked at the accounts of IRA investors and found that investors would make the contribution to their IRA close to the deadline and then leave the funds sitting in a money market fund for months on end.
CFP professional Maria Bruno, senior investment analyst in Vanguard Investment Strategy Group, suggests picking a default fund to serve as a parking spot for unallocated contributions.
"Make a balanced fund the default instead of a money market fund," she says. "A balanced fund or target-date fund is a very reasonable default."
Make sure that the fund chosen has a low expense ratio. Use Morningstar.com to compare the cost of your fund with the category average.
Avoid the procrastination penalty
Getting the contribution into the account is important, but it's also important to put the money to work for you for one simple reason: compounding.
There can be a big difference between making your contribution at your first opportunity in January versus butting up against the April deadline 15 1/2 months later. Vanguard's Bruno calls this phenomenon the "procrastination penalty."
"We ran hypothetical models and had a chart showing the difference between making a contribution on Jan. 1 versus April 15," says Bruno. "The give-up is about $15,000 over 30 years.
"It's completely hypothetical, but it could potentially make a big difference," she adds.
Contributions should be invested as soon as possible to make the most of compounding over time.
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