Minimize Risk and Maximize Returns in Your Roth IRA
Things to consider when making contributions
Since they were first established by the Taxpayer Relief Act of 1997, Roth IRAs have become one of the most popular retirement savings vehicles in America.
One major way that a Roth IRA differs from a traditional IRA is that there is no immediate tax deduction for annual contributions. But this is offset by the fact that Roth IRA contributions grow tax-free, instead of just tax-deferred. This can make a big difference in return over the life of the account.
As with any retirement savings vehicle, a primary goal of most Roth IRA investors is to minimize risk while maximizing returns. The secret to accomplishing this objective lies in proper diversification and asset allocation. These are the basic building blocks for retirement investors' long-term success, and they go hand in hand.
Diversification means spreading out the investments in your Roth IRA among different asset classes: primarily equities (or stocks), fixed-income instruments (or bonds) and cash equivalents (such as money market funds). The reason this is important is because the different asset classes usually do not move in the same direction at the same time. For example, when the stock market is rising, bond yields are often falling, and vice versa. So if one class of investments in your Roth IRA is performing poorly, the other classes may perform better, thus helping smooth out returns.
Asset allocation, meanwhile, is the means used to achieve the goal of diversification. It attempts to balance risk and return by adjusting the percentage of assets in a Roth IRA according to the investor's goals, time horizon and risk tolerance. For example, a Roth IRA's asset allocation might consist of 40 percent stocks, 40 percent bonds and 20 percent cash equivalents.
In a study conducted by Roger Ibbotson and Paul Kaplan, which followed up earlier research done by Gary Brinson, L. Randolph Hood and Gilbert Beebower, it was determined that asset allocation explains more than 90 percent of the quarterly variation in an investment portfolio's returns.
Taking asset allocation a step further, within the broad asset classes of stocks, bonds and cash instruments are further categories of asset types. For example, there are large-, mid- and small-cap stocks; international and emerging market stocks; corporate, municipal and Treasury bonds; money market funds; and certificates of deposit.
A well-diversified Roth IRA portfolio will include the proper mix of these different types of assets for the individual investor, based on certain criteria:
Goals: What are your overall goals for your Roth IRA? Saving for retirement is obviously one goal, but Roth IRA contributions (principal, not earnings) can be withdrawn without taxes or penalties before age 59 for any reason. This may make a Roth IRA a good choice for other financial goals as well, such as saving for a college education.
Time horizon: How many years are there between now and when you plan to tap into your Roth IRA to meet your goals, whether for retirement, the start of your child's college education or something else? The more time you have, the more aggressive you may choose to be in your asset allocation; you might allocate a higher percentage of your assets to stocks, for example, compared to bonds and cash instruments.
Risk tolerance: While a long-term time horizon makes it easier to assume more risk in your portfolio, since it gives you more time to make up short-term losses, you still need to do a serious self-analysis to determine just how much risk you're comfortable taking with your Roth IRA.
If you're the type of person who lies awake at night worrying when the stock market experiences volatility, you might be better off sticking with a more conservative asset allocation that includes a higher percentage of bonds and cash equivalents and a lower percentage of stocks. But if you can block out the short-term noise of day-to-day stock market fluctuations and keep your focus on the long term, you may benefit from the higher long-term return potential generally offered by stocks and stock mutual funds.
Be sure to contact us with any questions you may have or stop by to speak with one of our specialists.