The purpose of an individual retirement arrangement or IRA – including the Roth IRA – is to provide a flexible, tax-advantaged vehicle that can be used to save for retirement. As such, it was designed to hold a variety of investments for the long term – usually 20 years or more.
Safety – the main objective for retirement investments
The main objective of any investment for retirement is safety: You don’t want to invest in anything risky. You may enjoy investing in things like individual stocks or property, but we all know those can be risky investments. When it comes to your retirement funds, you want to stay away from things with inordinate risk.
Flexibility is a good thing (unless it’s a bad thing)
The fact that a Roth IRA can be used to hold a variety of investments is good news – it offers flexibility. What’s good about it is that you can invest in pretty much any type of investment through your Roth IRA – stocks, bonds, exchange traded funds (ETFs), mutual funds (including index funds), and even real estate.
The bad news is that you can invest in pretty much anything – including things which might not work for you. For instance, if you thought Twitter was going to be a good stock to invest in, you would be banging your head against a wall right now.
Consider this when selecting an investment
With a clear understanding of the purpose of an IRA – that it’s a tax-advantaged vehicle designed to help you save for retirement – we can begin to answer the question about which investments are best for a Roth IRA. Here’s what to consider:
- Funding. By far, the majority of the population earns their living from a job which typically gives them two paychecks every month – and the Roth IRA is perfect for that since you can easily put away a certain amount every month, a little bit at a time. But investing in rental property is quite a bit more difficult (effectively precluding that type of investment for many) because it requires a big chunk of money at a time.
- Automation. If you’re like most people, setting time aside to make investment decisions is a challenge because your life is a daily whirl of activity. The tactic most successful people use is automation: They have a set amount deducted from every paycheck which is then automatically deposited into their Roth IRA account. For automation to work, you want to pick an investment which lends itself to a set amount invested every two weeks or so.
- Basic investing concepts. 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. Here are a few posts on some important topics:
You may also want to Google articles on 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.
Which investments are best for a Roth IRA?
Once you take the considerations above into account, the list of appropriate Roth IRA investments gets narrowed down to three basic options:
- Index funds
- Exchange traded funds (or ETFs)
- Managed mutual funds
In general, these funds invest in indexes which are compiled and calculated independently – but to find out more about what index funds really are, you can refer to this article.
Two main attractions with index funds:
- Index funds typically offer the lowest cost to manage your investments. (Since you are not doing it yourself, there’s no escaping having to pay someone else. The goal, of course, is to keep that amount as low as possible.)
- Index funds generally outperform managed funds. You would think a mutual fund being run by a paid professional would do better than a market average, but history has consistently proven that to be a false expectation.
By far, the most popular index funds mimic the S&P 500 stock market index. There are other funds which purport to be index funds; however, they don’t track an actual index. (Bond funds, for example, are called index funds simply because they offer the low management costs commonly associated with index funds.)
Exchange traded funds (ETFs)
One of the benefits of investing for your retirement through a Roth IRA (or a traditional IRA, for that matter) is the fact that you are not restricted solely to mutual funds. With an IRA, you can invest in individual stocks, which opens the door to ETFs, which are nothing more than mutual funds which trade on a stock exchange just like stocks. (For more information on ETFs, see this article.)
Most ETFs are index funds, but they offer a wider array of specialized investments. For instance, if you want to invest in gold, there are several ETFs which allow you to do that. One such ETF (which uses the GLD symbol) actually owns the gold bars, and they hold more gold than all national governments except the big three.
ETFs offer low costs, but not always quite as low and the index funds referred to above. If cost is an important consideration for you — and it should be – take the time to check out all the costs of anything you want to invest in before you take the plunge.
Managed mutual funds
(For more on managed funds, see this article.) Although somewhat maligned recently, managed mutual funds still account for more than 70 percent of all retirement investment funds. There are a few reasons for that:
- Convenience. Managed mutual funds are usually the most convenient way to invest as an employee.
- Low risk. They are the oldest of the three options listed here, and have proven themselves to be pretty safe in terms of risk.
- Variety. They offer by far the widest variety of specialized investment options. For instance, if you don’t want any investment dealing with GMO, tobacco, or other issues, you are more likely to find a managed mutual fund to meet your needs than an ETF or index fund.
The popularity and wide variety of managed mutual funds comes with two penalties, though:
- High cost. Of the three options, managed funds usually are by far the most expensive. You may see rates which look low, e.g., 1.5 percent. Remember, though, that your long term return is unlikely to be more than 7 or 8 percent; that means they will be taking 20 to 50 percent of your annual growth. That’s a steep price for many.
- Bewilderment. It is not easy to distinguish between the bewildering arrays of managed mutual funds. They all seem to offer things like value and growth, and you never know which buzzwords are simply marketing gimmicks to get you to pick their fund.
When you consider that index funds and ETFs are generally simpler and cheaper, it’s easy to understand why they have grown much more in recent years at the expense of managed funds.
Most people consider the best way to invest through a Roth IRA is by putting your money every month into index funds. 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.
Part 1: The extraordinary power of compound interest
Part 2: What is a Roth IRA and why should you care?
Part 3: How to open a Roth IRA (and where to do it)
Part 4: Which investments are best for a Roth IRA?
Part 5: Questions and answers about Roth IRAs
[Editorial note: Since this article was originally published by J.D. Roth in 2007, we asked William Cowie to update the article for us.]
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