I've made my share of bad investments. I bought Papa John's (Nasdaq: PZZA) because I thought its pizza was the bomb. I bought Excite@Home (Nasdaq: ATHM), watched it shoot up 300% and then rush right back down again. I bought Akamai (Nasdaq: AKAM) after it had fallen 80% on the theory that it had already sloughed off its bubble valuation -- and watched it fall another 90% on me.
Those were mistakes that I made, learned from, and moved on. There is one mistake, though, that cost me much, much more dearly. Every year, it will have an increasingly profound negative impact on my future net worth. All my other foibles pale by comparison:
I bought now-defunct 3dfx Interactive in my Roth Individual Retirement Account (Roth IRA).
What is a Roth IRA?
The Roth IRA is a gift from the U.S. government to its citizens. It is a dreamland where you can store up to $2,000 annually (that number will ease its way up to $5,000 by 2008 under the new tax law), and that money can compound happily, joyfully, free from future income tax, as long as certain conditions are met. For people with a long time horizon before withdrawal, and for people who don't trust that income tax rates will be as low in the future as they are now, that totally rocks.
The Roth IRA isn't automatically better than the traditional IRA. The latter's main advantage is that it is deductible for qualified taxpayers (even if you don't itemize deductions) in the current year. Being able to avoid current taxes on $2,000 means that you've already earned a hefty return; that $2,000 could have cost you some $600 in taxes, depending on your tax rate. In essence, then, you've already made 30% by putting the money in a tax-deferred traditional IRA.
When you begin to take distributions from your traditional IRA, however, the government will tax them at your personal income rate at the time. If it has been raised to 50% by then, 50% it is. With the Roth, there will be no future taxes, if you stick to the requirements. Assuming that the investments in it will appreciate significantly over 35 years, and my income tax level won't fall substantially between now and the time of withdrawal, the Roth is ideal for me.
Both IRAs are tremendous savings vehicles, though. If you don't have one, get one immediately. Considering the immediate return on your tax bill that a traditional IRA offers, it's even good for people with credit card debt. Everyone should have an IRA. This calculator will help you decide which type is right for you.
The devil made me do it
As I said, IRAs are the gift of free money. One must make the most of them. They are pillars of our retirement savings, so we want them to be firm and strong. There are two temptations, however, that bedevil those of us who like to buy individual stocks.
The first is active trading. Since both types of IRAs make no distinction between short- and long-term capital gains, there is no penalty for holding stocks for a short period. This invites us to do any active trading that we want to do in our IRA accounts. The trouble is that active trading is not generally a successful endeavor for anyone other than experienced professional money-runners, as Terrance Odean found.
The second temptation is to put your Roth IRA money into speculative stocks. After all, if you can hold your big-time winners, the ones that appreciate 30,000,000% in a tax-exempt account, man, you've made it! Billions and billions of bones, and Uncle Sam can't touch 'em! Woo hoo!
Rule Breakers and Roths don't mix
I fell prey to the second temptation. When Roths came along, I rolled my traditional IRA, which had been in index funds, over into a Roth. Shortly thereafter, I got interested in 3dfx, a former component of the Rule Breaker Portfolio. I studied the company, got to know the product, and felt confident that it would be the 3D graphics supplier for every monitor and television in the next century.
3dfx's stock price had fallen to the point where I thought it was a sure thing, so I made the decision: I'd put 70% of my Roth money into 3dfx. If the $150 million company soon became a $1.5 billion company -- and how hard could that be? -- I'd have a 900% gain in just a few years. If it went to $15 billion, it would be a 100-bagger, all tax-free!
If you've followed this portfolio, you know that it didn't work out like that. In six months, I lost almost 50% of my investment. I cashed out with thousands of dollars in losses. The government had given me the opportunity to squirrel a limited amount of money away in a tax-exempt account, and I had blown it. It was just as bad as if I'd never thought to put money in an IRA at all. It was like I'd refused free money.
Be patient with retirement money
These days, I use my IRA for stocks that are well-established and pay meaningful dividends (why not shelter dividends, which are treated like regular income, from taxes too?), like Merck (NYSE: MRK) and Citigroup (NYSE: C), together with a healthy dose of index funds.
Time and patience are the greatest assets an investor can have. When you're young, every year that passes without funding an IRA means thousands, maybe tens of thousands less that you'll have for retirement in 30 or 40 years. Every underperforming investment has the same effect. Fund your IRA early and annually, and don't give in to the temptation of quick gains.
Brian Lund knows full well that he should never have bought Papa John's, or liked its pizza for that matter. Remember, you were young once, too. Of the stocks mentioned, he owns Citigroup and Merck. To see all his current holdings, visit his profile. The Motley Fool is investors writing for investors.