Unlike a 401(k), your IRA allows you to invest in any stock, bond, or mutual fund you want, which allows you to construct a retirement portfolio that meets your exact needs. While it can be fun to choose your own stocks as opposed to choosing investment funds in a 401(k), many investors make the mistake of taking on too much risk in their IRA. Here's a quick discussion of the risk (or lack thereof) that comes with choosing IRA stocks, and how much is too much.
Younger investors can afford to take more risk
It's a generally accepted rule that younger investors can take more risk than older investors. After all, if a recession takes a bite out of a 30 year old's portfolio, he or she has several decades to recoup those losses.
For this reason, older investors who rely on their portfolios for income should have more (but not all) of their portfolio in bonds, as these aren't as sensitive to economic issues as stocks and will produce a constant stream of income no matter what the market does. A good rule of thumb is to subtract your age from 110, and that is the percentage of your portfolio that should be in stocks. So, a 30 year old should have roughly 80% stocks and 20% bonds in their IRA. If you want to be a little more aggressive, subtract your age from 120.
And, the stocks in your IRA should meet some pretty distinct criteria, as I'll discuss a little later. However, older investors should stick to stocks that can perform well even if the market goes bad. For example, during 2008 the S&P lost nearly 38%. However, Wal-Mart and Family Dollar actually gained for the year, as their business models allow them to thrive during difficult times.
Younger investors have a little bit of "wiggle room" here to invest in slightly riskier stocks that are vulnerable to recessions and crashes, but are generally considered to be good investments over the long run. However, in an IRA, "risk" is a relative term. Even the riskiest stocks that are appropriate for an IRA should look tame compared to stocks that are usually considered to be risky or speculative.
But, don't confuse "risk" with "gambling"
Even though younger investors can afford to take on more risk, there is a big difference between higher-risk investing and speculation or gambling.
As an example, let's look at the financial sector. Most would agree that an investment in US Bancorp is about as low-risk as it gets, as far as banks go. For those investors with a little more risk tolerance, investing in Bank of America is a riskier investment than US Bancorp, but is still pretty safe. In other words, at least in my opinion, there is little chance of Bank of America going bankrupt or taking another massive hit, especially with the tougher bank regulations of today.
However, an investment in Fannie Mae is not much different than purchasing a lottery ticket. While it could pay off handsomely, there is an extremely high probability that Fannie Mae's shareholders will get wiped out completely. An investment like this is far too speculative to include in a retirement portfolio.
Just to give you a general idea of what I mean, here is an example of a low-risk stock from certain sectors, along with a riskier and a speculative example.
|Sector||Safe, low risk||Higher, but IRA-acceptable risk||Speculation/Gambling|
|Healthcare||Johnson & Johnson||Celgene||Amarin|
|Consumer goods||Wal-Mart||Dick's Sporting Goods||Aeropostale|
Now, I'm not saying that you should never speculate. If you truly believe that Fannie Mae will eventually return 10 times your original investment, go for it. Just don't do it with money you can't afford to lose, and the savings in your IRA is definitely in this category.
The right kind of IRA stocks
To find stocks that can work great in an IRA, there are a few things you should look for
- It must have an acceptable track record of revenue growth and profitability
- It should not have any realistic chance of bankruptcy anytime in the foreseeable future
- The company shouldn't have a high debt load
- It should be in a business that works in both good times and bad. For example, manufacturers of luxury items tend to get crushed when the economy goes bad
This is by no means an exhaustive list, but a little research will show you that all of the stocks in the "safe" column above definitely meet all of these requirements. For more examples of great retirement stocks, you can read this article.
As a final thought, keep in mind that with an IRA, it's better to err on the side of caution. After all, it's better to end up with less money that you could have made than to end up with less than you started with as a result of taking on too much risk.
Matthew Frankel owns shares of Bank of America, Caterpillar,, and Petroleo Brasileiro S.A. (ADR). The Motley Fool recommends Bank of America, Celgene, Facebook, and Johnson & Johnson. The Motley Fool owns shares of Bank of America, ExxonMobil, Facebook, and Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.