Best Buys for Your IRA

Use them to shelter yourself from tax bills.
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Editor's note: As a special feature for April, TheStreet.com is offering a seven-part series on maximizing your IRA. This installment is Part 4. Click here for Part 1, Part 2, Part 3, Part 5, Part 6 and Part 7.

You can put anything in an IRA, from bank CDs or Treasury bills, which are virtually risk-free, to highly risky investments such as individual Chinese stocks. Where your own IRA investments fall in this range of risk parameters depends on:

  • The size and character of your overall investment portfolio.
  • Your individual attitude about taking risk in the financial markets.
  • How long you have been investing.
  • How much time you want to devote to managing your own investments.

The term "risk" is usually used to describe the volatility of investment returns. A high-risk investment might be up 100% one year but down 50% the next. This type of volatility is unacceptable to most investors. On the other end of the spectrum, a low-risk investment might increase in value at 3% to 5% per year for many years.

Generally, risk and return are positively correlated: Riskier or more volatile investments tend to produce higher returns over the long run. Investors demand this additional compensation for putting their money into more volatile investments. In general, common stocks tend to provide higher returns over the long term than bonds, and bonds tend to provide higher returns than money-market funds.

Perhaps you are very new to investing and this is the first year you have contributed to an IRA. Let's further assume that this new IRA is the only investment you own, other than a savings account at the local bank that you use as a reserve fund for emergencies. If you're nowhere near retirement, it probably makes sense to put your initial investment in a stock mutual fund or exchange-traded fund.

If, on the other hand, your IRA represents only a small part of your total investment portfolio, it can be much more concentrated. You can use it to house a single security or asset class. Assuming you have a choice about how to balance your investments, it would be advantageous to put the investments that generate the biggest tax bills in an IRA.

For example, if you want to allocate 60% of your portfolio to stocks and 40% to bonds, you should keep the bonds in an IRA. That's because the interest that bonds pay is taxed as ordinary income, whereas the long-term capital gains generated when you sell stocks held for more than a year are taxed at a lower rate. If, like me, you have substantial short-term capital gains due to investment activity, your IRA would be a good place to concentrate that activity.

Another advantage to putting your least tax-efficient investments in IRAs is that it simplifies your tax returns. It's not necessary to report gains and losses on the individual investments held in an IRA, so you won't have to spend hours slaving over Schedule D forms.

The conventional wisdom is that younger investors can tolerate more volatility than older investors because they have a longer-term time horizon. But that doesn't apply to everyone. If you're going to be pacing the floor all night because your portfolio is down 15%, you should only consider an investment approach that severely limits this possibility.

How can you do that? By owning enough short-term fixed-income instruments to dilute the impact of fluctuations in the more volatile segments of your portfolio, usually represented by common stocks.

I'm a strong believer in diversification. If you're just starting out, this means that you will probably want to use mutual funds or ETFs as investment vehicles. Personally, I would recommend going with a low-cost index fund such as those offered by

Vanguard

, or the use of

Spyders

(SPY) - Get Report

, an exchange-traded fund that tracks the

S&P 500

index, for the equity portion.

There is no evidence that it's possible to pick an actively managed mutual fund that will outperform the overall market over time.

There are also mutual funds and ETFs that track bond indices.

Using index funds and ETFs satisfies a couple of important requirements. First, your portfolio will track the market, reducing your anxiety. You may still lose some sleep when the market is down, but you won't have to worry about your fund underperforming the market. Second, investing in index funds is easy and doesn't require much time. The only thing you need to worry about is occasional rebalancing to keep your portfolio in line with your asset-allocation objectives.

If you have a larger portfolio, you may still want to use index funds or ETFs. There are plenty of alternatives that allow you to track a wide range of assets, including foreign stock markets or individual industries. The more complex the approach, however, the more time you will probably have to spend monitoring your investments.

As I said, my own approach is to reserve my IRA for U.S. common stocks that I usually hold for less than a year. I have other investments outside my IRA, including real estate, fixed income and oil and gas royalties, so my total investment portfolio is well diversified. This approach keeps me very busy, and I spend a couple of hours each day following my stocks and looking for new ideas to invest in. It is time-consuming, but it is something I love to do, and the results so far have made the time spent worthwhile.

Coming up next: A more detailed description of Moore's own investment approach.

Richard Moore, CFA, has 40 years of experience in various facets of the investment business. He has been employed by banks, mutual funds and investment advisory organizations during his career and has also owned retail and service businesses. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Moore appreciates your feedback;

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