If you've started an individual retirement account (IRA) and contribute to it regularly, you're already setting yourself up for success. If you contribute the max each year, you're doing even better. Once you've gotten the behavior down, though, it's time to start learning about asset allocation. Asset allocation is, simply put, diversifying your investments by holding different investment vehicles (such as stocks, bonds, real estate, cash, or commodities). There are three important factors to consider when determining how to diversify your IRA.
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1. Investing horizon
An investing horizon is the amount of time you have before you need the money in your investments. Investing horizons can be anywhere from 10 years if you're growing a college fund to 40 years if you're saving for retirement. If your horizon isn't your planned retirement age, you should be saving in a non-retirement account so you don't pay withdrawal penalties.
Since we're talking about IRAs, the horizon we'll work with is retirement. If you start your IRA when you're 25, you probably have about 40 years before you start taking withdrawals (unless you wait until the mandatory withdrawal age of 72 for most people). With all of that time, you can afford to take more risks with your asset allocation (more on risk later). While that doesn't mean you should be buying penny stocks in your IRA, it does mean you can truly harness the power of compounding by investing for growth when you're young. Since you have so much time on your side when you open an IRA young, you can use capital gains and dividends to purchase more stock and grow your money exponentially.
With a shorter horizon, you will want to move to lower-risk assets. While you won't enjoy the same growth in these vehicles (we're talking money market accounts, bonds, real estate, or large-cap stocks), you will enjoy monthly cash flow in the form of dividends, rent, or interest. It's important to keep an eye on your horizon and evaluate your IRA asset allocation on a regular basis; most seasoned investors will rebalance their investment portfolios every year or so to make sure they're still on track.
2. Risk tolerance
Somewhat related to your investing horizon is your risk tolerance. At least, it should be tied to your horizon. Everyone has a different risk tolerance, and it's your job to figure out yours. If you're a belt-and-suspenders kind of person (you take extra precautions to make sure your pants don't fall down), you probably don't want to invest too heavily in small-cap or foreign stocks; you'll have daily heart attacks as you watch your IRA balances fluctuate. On the other hand, if skydiving or free solo climbing is more your jam, you might be bored with low-yield bonds or with large-cap stocks that pay dividends.
In other words, your own individual tolerance for risk is a crucial factor to consider when determining your IRA asset allocation. Those who can psychologically handle fluctuating balances and possible losses of capital can invest in riskier assets with higher potential returns.
3. Asset class (diversification)
Finally, you'll need to consider what types of assets you want to hold. Broadly speaking, there are six asset types you can hold in your IRA -- stocks, bonds, funds, real estate, commodities, and cash. While Warren Buffett may disparage heavy diversification, it is general investing wisdom to achieve some level of diversification in order to spread out risk and take advantage of potential rewards by capturing gains in different sectors, industries, or assets.
Each asset type carries with it its own benefits and disadvantages. Stocks may appreciate in value, but the company could also go bankrupt. Most bonds pay lower yields, but short of an apocalypse, you're going to collect that interest (particularly on government-backed bonds). Real estate may not appreciate quickly, but it provides significant tax advantages and generates regular cash flow. Cash doesn't appreciate at all, but it's highly liquid and the only value it will lose is based on inflation. Commodities are highly risky and largely speculative, but offer a tangible asset and have high potential payouts. Having a diversified portfolio means you can take advantage of booms in different markets while hedging against busts in others.
Nobody is doing it for you
Nobody will ever care about your retirement accounts as much as you do. You can get actively managed IRA accounts that will adjust your investments based on your age and risk tolerance, but you'll pay for that convenience. And ultimately, it's still a fallible human making the decisions. Knowing the basics about asset allocation puts you in control of your retirement account. Plus, keeping these three considerations in mind while making decisions will help keep you from investing arbitrarily, or worse, just putting your money in a money market account with less than a 0.5% return.
