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Roth IRA: How to invest & diversify

Steve Widoff

In the landscape of personal finance, where every move is a stepping stone toward financial freedom, your Roth IRA strategy is a key navigational tool. When you know how to approach your Roth IRA investments, you can more clearly visualize your retirement goals—no matter how near or far away they are.

Read on to learn about choosing investments based on your risk tolerance and time horizon, and how to diversify a Roth IRA with the right asset mix to suit your financial goals.

5 steps to evaluate your Roth IRA investment strategy

Figuring out which investments in a Roth IRA are right for you involves knowing more about your investor personality—your goals, risk comfort, timeline and asset preferences. Going through these can help you make informed decisions:

  1. Define your investment goals. Clarify the purpose of the Roth IRA. Is it for retirement, another specific financial goal or a combination of objectives? What you want to accomplish will guide your investment strategy.
  2. Assess your risk tolerance. Risk tolerance is your ability and willingness to endure fluctuations in the value of your investments. It's crucial to choose investments that are aligned with your comfort level so you have confidence in your strategy.
  3. Be aware of your time horizon. Your goal timeline is key for gauging how you want to balance the potential of compounding investment returns with the potential of investment loss. With a long time horizon, you may be more open to taking on risk because you have time to recover if needed—and the opposite if you have a short horizon.
  4. Understand diversification. When you diversify, you spread your risk across different asset classes (i.e., stocks, bonds, real estate) or different industries. Having a range of investments can reduce the impact of poor performance in any single investment.
  5. Choose your approach: Active vs. passive investing. Will you want to play a hands-on role on your portfolio decisions and management, or would you prefer to "set and forget" a pre-set mix of investments? Those options, or a mix of both, can help you balance risk and control.

Options & types of investments for your Roth IRA

Unlike traditional IRAs, Roth IRAs can grow tax-free—making the types of investments within your Roth IRA all the more important. Most people select from an assortment of dividend stocks, dividend funds, growth funds, S&P 500 funds or high-yield bond funds. Some investors create a combination of them, and it's a good idea to regularly shift tactics as retirement assets grow and as factors like risk tolerance and time horizon change.

Here's a breakdown of some of these investment options within a Roth IRA:

Dividend stocks

Dividend stocks are shares of companies that distribute a portion of their profits to shareholders in the form of dividends. They're typically paid out regularly, usually on a quarterly basis, providing investors with a stream of income.

Retirees are often attracted to dividend stocks for the ongoing income they can generate. Dividend stocks also offer the potential for capital appreciation while potentially providing more stable returns than growth investments.

Dividend funds

Dividend funds are mutual funds or exchange-traded funds (ETFs) that focus on investing in a diversified portfolio of dividend-paying stocks. These funds pool money from various investors to buy a diversified mix of dividend stocks. The fund manager selects and manages the portfolio, distributing dividends to investors. Or you can choose to reinvest them back into the fund.

If you want instant diversification, professional management and the potential for regular income, you may want to go for dividend funds.

Growth funds

Growth funds are mutual funds or ETFs that invest in stocks of companies with high potential for capital appreciation. These companies often reinvest their earnings to fuel further growth.

While growth investments tend to be riskier than dividend funds with wider price fluctuations in the short term, they can provide higher returns over time. This can make them a good fit for people with high risk tolerance and a long time horizon.

S&P 500 funds

S&P 500 funds are mutual funds or ETFs that track the performance of the Standard & Poor's 500 index, which includes 500 of the largest publicly traded companies in the U.S. With these funds, you essentially own a small piece of each of the 500 companies in the index, providing broad market exposure.

While these funds offer diversification across major U.S. companies and have historically had strong returns, the entire idea behind it is that it's average. Aggressive investors may not be satisfied with the rate of return, and investors with a short time horizon might not like how closely it mirrors the ups and downs of the market.

High-yield bonds

High-yield bonds, also called junk bonds, are debt securities issued by companies with lower credit ratings. They offer higher yields to compensate for the increased risk. These bonds work by having investors lend money to the issuer in exchange for periodic interest payments and the return of principal at maturity.

While high-yield bonds offer the potential for income and greater returns than investment-grade bonds, they can decline in value, especially in economic downturns.

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Choosing & diversifying your Roth IRA investments

As you decide how to invest with your Roth IRA, you may choose to put all your money in one mutual fund, or you may want to diversify. Diversifying involves spreading your money across different asset classes to reduce risk and optimize potential returns. This approach aims to enhance the overall resilience of your portfolio, ensuring a balanced exposure to different market conditions and providing a well-rounded foundation for long-term wealth accumulation in your tax-advantaged Roth IRA.

Here's what to consider as you build your Roth IRA investment strategy:

Determine your asset mix

Your asset mix, or asset allocation, is the percent you allocate to the primary asset types, such as stocks, bonds and cash. Decide on an asset allocation that aligns with your goals and risk tolerance. Asset allocation involves dividing investments among different categories based on their expected risk and return.

The greater your risk tolerance and time horizon, the higher the allocation to stocks; the lower your risk tolerance, the more your asset mix will be tilted to bonds.

Asset mix example

Hypothetically, a young investor with high risk tolerance and a time horizon of more than 10 years until retirement might allocate 70% to 90% of their investments to stocks and 10% to 30% to bonds. A retired investor with lower risk tolerance, on the other hand, might allocate 30% to 50% to stocks and 50% to 70% to bonds.

Select your investments

Once you've clarified your risk tolerance, time horizon and financial goals and decided on an asset allocation, you can select your investments.

To provide an example using dividend stocks, dividend funds, growth funds, S&P 500 funds and high-yield bonds, let's say you have a medium risk tolerance and you're saving for retirement, which is 20 years away. Here's how your investment selection might look based on a 60/40 asset allocation:

  • Put 60% in stocks. Some investors prefer to use S&P 500 index funds for their entire stock mix because they invest in the 500 largest U.S. companies, which includes a diversified mix of growth stocks and dividend stocks. If you prefer to create your own mix, you may choose 30% dividend stocks/funds and 30% growth funds.
  • Put 40% in high-yield bonds. While bonds are income-generating investments often used for retirement income, they also can be used for diversification purposes in a long-term portfolio.

The bottom line on your Roth IRA investment strategy

Remember that the right investments for a Roth IRA depend on individual circumstances, and there is no one-size-fits-all approach. Periodic reassessment and adjustments are essential to ensure your investments remain aligned with your financial objectives.

Individual financial goals and risk tolerances vary, and it's essential to tailor investment decisions to your specific circumstances and your overall financial goals. Consulting with a financial advisor can provide you with guidance that's personalized to your situation and goals.

While diversification can help reduce market risk, it does not eliminate it. Diversification does not assure a profit or protect against loss in a declining market.

Dividends are not guaranteed.

Hypothetical example is for illustrative purposes. May not be representative of actual results. Past performance is not necessarily indicative of future results.

An investment cannot be made directly in an unmanaged index.

Investing involves risk, including the possible loss of principal.