This is part three of the GRS introduction to Roth IRAs. You may wish to begin with parts one and two.

I used to believe the stock market would make me rich. All I needed to do was pick the right stock and I’d be a millionaire. In March of 2000, I decided that stock was PALM, which I bought the morning it went public. Within days my $1,000 investment was worth $600, and my fantasies of instant wealth were swept out the door. My mistake was a desire to get rich quickly — greed clouded my vision. I was uneducated. I didn’t understand how investing worked. In time, I learned a better way.

Now that we’ve discussed what an IRA is, and learned how to open one, it’s time to explore investment options. You can use your Roth IRA to make just about any investment you want. Because this site is about the slow, sure path to wealth, I’m going to focus on a few choices that make sense within this philosophy. I can’t tell you exactly which stocks or mutual funds you should buy, but I can give you some ideas.

Remember: I am not a financial professional. I’m just a regular guy trying to learn about money and then share the information with you.

Reviewing the basics

It’s a mistake to jump into investing and make your decisions blindly. Before you begin any investment program, it’s important to have an understanding of basic concepts. If you feel lost, I recommend that you set aside some time to review Michael Fischer’s video series on Saving and Investing. You can find a complete list of episodes in my list of financial literacy resources. Some of the most relevant to this discussion include:

You may also want to do some reading about risk tolerance and asset allocation. To learn more about investing, head to your library and borrow one of the following books:

These books will help you become acquainted with concepts like asset allocation, diversification, risk tolerance, stock valuation, and more. The better educated you become, the better investment decisions you will make.

Common sense investing

After reviewing the basics, you can probably guess which investment philosophy I espouse. For most people, there’s a simple investing solution recommended by a wide range of financial experts: Buy low-cost, diversified mutual funds in your IRA. It’s that simple. Purchasing index funds is a great way to do this, but there are other options.

There are several thousand mutual funds available in the United States alone. There are mutual funds for those interested in socially-responsible investments. There are mutual funds for those who like tech stocks. There are mutual funds based around Biblical principles. There are mutual funds designed to mirror the performance of a stock index. There are mutual funds that attempt to beat the markets in an aggressive fashion. There are junk bond mutual funds. There are real estate mutual funds. There are foreign funds. There are mutual funds that target specific retirement dates. You name it, and there’s probably a mutual fund for it.

As an example of the variety available, check out the “periodic table” of Vanguard exchange-traded funds:

Picking mutual funds is like picking stocks: your choice depends on your objectives, how long you wish to invest, and on your risk tolerance.

However, as I wrote in January, many investment experts recommend the same slow, sure path to wealth: invest your money in index funds. Index funds are low-maintenance, low-cost mutual funds designed to follow the price fluctuations of a broader index, such as the Dow Jones Industrials or the S&P 500. They are boring investments, but they work. (If you’re investing for the excitement, you’re doing it for the wrong reason.)

Investing on auto-pilot

If you’re a do-it-yourself type and like to pick and choose your own funds, then Vanguard’s Total Market Stock Index Fund is a good place to start, and is consistent with the “get rich slowly” philosophy. (Similar funds are available from T. Rowe Price and Fidelity.) Begin by buying the market as a whole, and then branch out as you learn more about investing.

However, if you’re a set-it-and-forget-it type, then you might want to pick a “life-cycle” retirement fund. Advantages of a life-cycle fund include:

  • You get instant international exposure. A life-cycle fund is a “fund of funds”, including some international funds.
  • You get automatic asset allocation, since you’ll cross asset classes.
  • You’ll get automatic rebalancing, and Vanguard will even change your asset allocation to become more conservative as you approach retirement.
  • You can pick a fund according to your risk tolerance.  You don’t have to pick a fund that coincides with your retirement date.  If you are interested in more growth (and don’t mind the higher risk), you simply pick a fund with a retirement date later than your actual planned retirement date.  Vanguard (or T. Rowe Price or Fidelity) will just postpone their moves to a more conservative allocation in accordance to the retirement date on the fund.

The drawback, of course, is that you have no control.  For example, if you want your international allocation of equities to be 50% (or more!), you’re out of luck.  Some people are okay with that, but the lack of control makes others crazy. You should do what works for you.

Each of the Big Three has varying degrees of aggressiveness/conservatism for any given retirement date.  Choose the retirement fund that fits your risk tolerance. Important note: If you choose to go with a life-cycle fund, commit to that fund. If you spread your money around (especially to other life-cycle funds), you defeat the purpose.

Exchange-traded funds

If you open a Roth IRA with a mutual fund company, it makes sense to select from the products they offer. If your Roth IRA exists with some other financial institution, you may still be able to invest in the mutual funds from these companies. But some brokers — such as Sharebuilder — only allow trading in exchange-traded funds (ETFs), which are mutual funds that trade like stocks. They are bought and sold through the market instead of through the mutual fund companies.

There are many exchange-traded index funds available — the Vanguard “periodic table” mentioned earlier is composed entirely of ETFs. As an example, my Roth IRA, which is with Sharebuilder, currently contains:

  • QQQQ, an index fund that tracks the NASDAQ stock market index
  • IWD, an index fund that tracks a subset of the Russell 1000
  • EFA, an index fund that attempts to mirror the MSCI EAFE index of international stocks

I’m not recommending these funds for you, but these seemed right for me. A life-cycle fund doesn’t appeal to me. I like to be able to have some control over my investments.

Don’t worry about exchange-traded funds unless they’re your only option. Because of their lower costs, beginning investors are better served by focusing on normal mutual funds. (The Wikipedia has a section on the differences between ETFs and traditional (open-ended) mutual funds.)

Conclusion

In this discussion, I’ve focused on mutual funds — particularly index funds — because I think they’re the best choice for most investors. They typify the “get rich slowly” ideology. Some of you will want to purchase individual stocks in your Roth IRA. Some will want to purchase real estate, or invest in precious metals. If you make educated decisions, these can be excellent moves. However, for most investors, index funds are a smart way to own a piece of the market while mitigating risk.

After reading this article, many people will still be uncomfortable making their own investment decisions. There’s no shame in this. For these people, I recommend speaking with a financial advisor. My wife does this, and it makes her much happier than if she were to pick investments on her own. Earlier this year, I published a reader question about finding a financial advisor. In April, Dylan shared a guest entry explaining when and how to hire a financial planner.

Here’s some additional reading related to these topics:

In the final part of this series on Roth IRAs, I will research answers to your questions. If there’s something that I didn’t cover in these first three sections, or things that still puzzle you, drop me a line.

Remember: I’m just learning about IRAs myself. I’m sure to have missed some things. Not all the information here is necessarily complete or correct for your situation. I’ve done my best to be accurate, but this is only an overview. It’s important to do your own research. I am not a financial professional — I’m just a regular guy trying to learn more about money. Thanks to Vintek, who wrote most of the “investing on auto-pilot” section.