3 key considerations for perfecting your IRA asset allocation

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If you have started a individual retirement account (IRA) and contribute regularly, you are already setting yourself up for success. If you contribute the most every year, you do even better. Once you’ve mastered the behavior, it’s time to start educating yourself about asset allocation. Asset allocation is, in simple terms, diversify 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. Investment horizon

An investment horizon is the time you have before you need the money in your investments. Investment horizons can range from 10 years if you are growing a university fund to 40 years if you are saving for retirement. If your horizon is not your expected retirement age, you should save in a non-retirement account you therefore do not pay withdrawal penalties.

Since we are talking about IRA, the horizon we will be working with is retirement. If you start your IRA at age 25, you probably have about 40 years to go before you start making withdrawals (unless you reach the squeeze-out age of 72 for most people). With all this time, you can afford to take more risk with your asset allocation (more risk later). Although that doesn’t mean you should buy penny stocks in your IRA, that means you can really harness the power of compounding by investing for growth when you’re young. Since you have a lot of time when you open a young IRA, you can use capital gains and dividends to buy more stocks and grow your money exponentially.

With a shorter time horizon, you’ll want to switch to less risky assets. While you won’t enjoy the same growth in these vehicles (these are referred to as 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 is important to keep an eye on your horizon and regularly assess your IRA asset allocation; more seasoned investors will rebalance their investment portfolios approximately every year to ensure they are always on track.

2. Risk tolerance

Your risk tolerance is somewhat related to your time horizon. At least he should be linked to your horizon. Everyone has a different tolerance for risk, and it’s up to you to determine yours. If you’re the belt and suspender type (you take extra care to make sure your pants don’t fall off), you probably don’t want to invest too heavily in small-cap or foreign stocks; you will have daily heart attacks when you observe the fluctuation of your IRA balances. On the flip side, if you’re more into skydiving or free climbing solo, you might get bored with low-yielding bonds or large-cap stocks that pay dividends.

In other words, your own self risk tolerance is a crucial factor to consider when determining your IRA asset allocation. Those who can psychologically handle fluctuating balances and possible capital losses can invest in riskier assets with higher potential returns.

3. Asset class (diversification)

Finally, you will need to consider the types of assets you want to hold. Broadly speaking, there are six types of assets that you can hold in your IRA: stocks, bonds, funds, real estate, commodities, and cash. While Warren Buffett Can disparage high diversification, it is generally wise to achieve a certain level of diversification in order to spread the risk and take advantage of the potential rewards by capturing gains in different sectors, industries or assets.

Each type of asset has its own advantages and disadvantages. Actions may increase in value, but the business could also go bankrupt. More obligations pay lower yields, but barring an apocalypse, you’re going to earn that interest (especially on government guaranteed bonds). Immovable may not appreciate quickly, but it offers significant tax benefits and generates regular cash flow. Cash does not appreciate at all, but it is very liquid and the only value it will lose is based on inflation. Commodities are very risky and largely speculative, but they offer a tangible asset and have high potential gains. Having a diversified portfolio means that you can profit from booms in different markets while protecting yourself from recessions in others.

Nobody does it for you

No one will ever care more about your retirement accounts than 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 this convenience. And ultimately, it’s always a fallible human who makes the decisions. Knowing the basics of asset allocation gives you control over your retirement account. Also, keeping these three considerations in mind when making decisions will help you avoid investing arbitrarily, or worse, simply placing your money in a money market account with a return of less than 0.5%.

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