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Answering Your IRA Questions
Q. Where should my IRA money be invested? There are so many choices that it's hard to figure out.
A. For most people, the purpose of an IRA is to accumulate money for retirement and to let that money grow as much as possible. In general, I believe your IRA should be invested in the most aggressive investment available that is prudent, considering the time remaining until you may need that money. In most cases, IRAs should be invested in equities through diversified no-load mutual funds. Investors with less than a decade before retirement may want to gradually shift some of their investments into bond funds to reduce volatility. But doing that will reduce the IRA's likely return, and most people will be best served by keeping a healthy dose of equities in their IRAs.
To be more specific, if you have at least a half dozen years before you will need your money, I believe you should invest your IRA in funds that give you a legitimate chance for a 10 to 15 percent compound rate of return, which will double your money approximately every five to seven years. Prudent investing also calls for a defensive strategy to protect yourself from significant market declines. I believe the best way to achieve that is through market timing, either by timing your funds yourself (for instance, by using the timing signals available to Fund Exchange subscribers) or by investing in a fund that employs internal timing or some other defensive strategy.
Q. I recently heard you say that market timing is a lifetime discipline. I like your reasoning, Paul, but I'm just not sure I trust market timing enough to lock myself into it for 30 years. Isn't that an awfully long time?
A. Yes, 30 years is a long time and a lot can happen in that time. If I had to make only one prediction and live with it for the next 30 years, it would be that we will experience at least one major bear market with equity prices declining 50 percent or more. If that happens, I am sure you won't want to be locked into an investment that forces you to ride such a market from top to bottom.
The fact that you are reading this newsletter tells me you see some value in market timing. However, if you are uncomfortable with this discipline, why not invest half of your IRA following my market timing suggestions and the other half using your own judgment and instincts? Over time, that will provide an interesting comparison of returns. And you can always shift money from one strategy to the other if you wish to do so.
Q. I have some extra income I could put into an IRA, but my husband says we should use the money to pay down our mortgage balance instead. Even though that won't reduce our monthly payments, he says it will save us a great deal of money in interest and help us get out of debt. Then we will have much more money to put into an IRA. First things first, he says. What do you think?
A. Your husband's preference for paying down the mortgage balance is in line with numerous books, magazine articles and a lot of standard financial advice. The theory is that paying off debts is more prudent than taking investment risks and being out of debt is a laudable financial goal. I agree with that completely in regard to credit card balances and other consumer debt with interest rates of 15 percent or more. The interest on those debts does you no good, it's not deductible and it's just a financial drain.
However, the real benefit of an IRA, as you can see from the discussion above, is its ability to compound investment returns over very long periods of time. One of the biggest financial mistakes most people make is putting off serious investing until other things are taken care of. By doing that, they squander their greatest financial resource: time. Once you lose that time, whether it's a year, a decade or a quarter century, you can never get it back. This is one race in which, if you start late, you are unlikely to ever catch up.
Because the critical element in investing is starting early, I am on your side of this disagreement. Your mortgage will gradually take care of itself. Like your husband, I believe in doing first things first. In your case, I think that means using your extra income first to maximize your tax-deferred savings opportunities. When you have done that, then whack away at the mortgage balance.
To show you the difference, imagine a 25-year-old worker who contributes $2,000 annually to an IRA for 10 years, until he is 35, then stops. Assuming he earns a compound rate of return of 10 percent, when he is 65 his IRA will be worth $611,817. All that came from investments of only $20,000.
Now imagine another chap, also 25, who uses $2,000 a year to prepay his mortgage balance from age 25 to 35. Then at age 35, he starts putting $2,000 a year into his IRA and keeps doing so for 30 years until he is 65. Assuming the same 10 percent rate of return, at age 65 his IRA would be worth $361,887-after $60,000 total investments. By age 65, both mortgages are paid off. But one worker has a quarter of a million dollars more money for retirement than the other. It's your choice, but it seems like a pretty obvious choice to me!
Source: http://www.fundadvice.com
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