Mutual Fund Monday - Dagen McDowell

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Dear Dagen: What Funds Should I Buy Now in My Roth IRA?

Dagen McDowell

I need to put $3,000 into a Roth IRA by April 15. I am 26 years old and a novice investor. I would like to put this money into some sort of mutual fund or funds but I'm unsure about what type of fund in which to invest. Do you have any suggestions?

Brett

The advantage of investing through an IRA instead of a 401(k) is that you get to choose any mutual fund you like.

And the disadvantage is that you get to choose any mutual fund you like.

When you go to pick a fund at random, the choices can be overwhelming. Finding a spouse seems easier. There are, after all, about 6,000 different funds in this country.

You simply need a strategy that will winnow that list down and prevent you from going for the first fund that looks decent.

Don't Buy Anything

First, you only need to make a contribution to your IRA by April 15. You don't have to pick a stock or bond fund by that date as well. You can put your $3,000 in the IRA (Roth or otherwise) and take your sweet time deciding what investment to actually buy. The money can sit in a money market fund while you research funds or other options.

An IRA isn't an investment, like a stock, bond or fund. It's only a type of account. It's a wrapper of sorts of that goes around your money and lets it grow tax-deferred.

Shoot. Your cash can simply stay in a money market fund if you're really afraid of the stock market. But with decades to go until your retirement, you can and should take on more risk than that. No risk, no reward.

The Simple Plan

Keeping most of your money in stocks should produce the biggest booty over time. The idea is that you get paid for taking on risk. And stocks over longer stretches of time should produce higher returns than bonds. According to data from Charles Schwab, a portfolio with 95% in stocks and 5% in stocks and cash produced an average annual return of almost 11% from 1970 through 2002. But one with just 20% in stocks delivered 9% a year over that same period.

Of course, all that stock exposure brings a lot more volatility. The S&P 500 fell 22% last year. You have to ask yourself: Can you stomach that kind of plunge? That might not happen again for years to come but it certainly could.

Frankly, most investors -- even ones in their 20s -- could use some bonds in their portfolios. And assuming that you haven't overdosed on bonds like so many other investors in the last two years, you need some stocks and bonds and cash.

You can get all three with just one mutual fund. You can buy a balanced fund that invests in individual stocks and bonds, like the (EBALX)Eclipse Balanced fund. But very often, a balanced fund will have a set allocation of, say, 60% in stocks and 40% in bonds, which doesn't vary too much. And frankly, that asset mix is probably too conservative for someone who's going to retire in another 30 or 40 years.

Instead you can look for a stock and bond fund that will age with you. Fidelity offers six asset-allocation funds called its Freedom funds, which invest in other Fidelity funds. The allocations in these funds will get more conservative as you get closer to retirement. You only have to match your retirement date to the number in the fund's name. The (FFFEX)Freedom 2030 fund, for instance, is designed for investors who are going to retire in just under 30 years. The fund owns 13 different stock funds and five bond funds.

Vanguard also offers several funds that invest in the firm's own funds. Its so-called LifeStrategy funds are geared toward different levels of risk. Unlike the Fidelity Freedom funds, these portfolios won't change their allocations over time. But that's a small sacrifice for funds that are so cheap. The (VASGX)Vanguard LifeStrategy Growth fund, for example, owns three broad Vanguard index funds and its (VAAPZ)Asset Allocation fund. Plus, it only costs 0.28% a year to own.

Taking Advantage of the Tax Deferral

If you want to get a little more complicated with your IRA, you can go with a fund that could really use the benefits of tax deferral. These are funds -- like bond funds -- that generate a lot of income every year, which you will have to pay income taxes on. Within a traditional IRA, you can postpone paying those taxes until the money comes out at your retirement. And in a Roth IRA, you won't pay any taxes at all when you withdraw that money in your later years.

At such a young age, you probably don't need too much of your money in bond funds. But a high-yield or junk bond fund might be worth a look if you already have a broad stock-market fund stashed somewhere else.

High-yield bonds are backed by companies with shaky financials and are the riskiest bonds you can buy. But these bonds pay you higher yields to compensate you for taking on that risk. And the higher the yield, the more taxable income they produce. Plus, these bonds are sporting attractive valuations.

The (VWEHX)Vanguard High-Yield Corporate fund is the cheapest junk bond fund you can buy, charging 0.27% every year. The average high-yield fund takes a full percentage point more every year. The (PRHYX)T. Rowe Price High-Yield fund also has low fees.

And that's one thing to remember whether you buying a fund inside or outside an IRA: Cheap is good.