Best Ways to Invest an IRA

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What would you suggest an IRA portfolio consist of for a 45-year-old with about $100,000 to invest? Are you at liberty to say what organizations give better returns with fewer fees? We are very green at this and any advice would be helpful. —Denise

I've long since adopted the chief investment criterion of the late, great economist Paul Samuelson: sleeping well at night. But without knowing you, I can't figure out how much risk would keep you awake.

Risk, Reward and Investing

The first principle of investing is completely straightforward: risk = reward. Practically speaking, the greater the reward, or "return," an investment offers, the greater the risk it entails.

For example, last I looked, you could lend money to Egypt for 10 years by purchasing a 10-year Egyptian bond. The promised interest rate: 16+ percent. By vivid contrast, buy a U.S. 10-year bond or note and you'll get one-tenth that return: a measly 1.6 percent or so.

Why? You tell me. Lending money to Egypt is way riskier, right? There’s the risk that Egypt won't pay back the money (default) and the risk that Egypt will begin printing pounds as if there's no tomorrow (inflation).

So, how much risk can you tolerate before you hit the Ambien?

To answer that question, you might want to use an online investment calculator that can give a general idea of your risk tolerance. I rather like the Investment Risk Tolerance Quiz on the Rutgers University website, developed by two personal finance professors.

A Rule for Asset Allocation

Once you have a sense of your risk tolerance, the next decision is "asset allocation": the percentage of your assets to put into stocks (risky) and bonds (safer).

A hoary rule-of-thumb is that the percentage of bonds in your investment portfolio should equal your age. In your case, that would mean putting about 45 percent of your IRA in bonds.

My wife and I, in our late 60s, are pretty close to being on target. (Here's our asset allocation as of a year ago.) The only change since then is the orange slice: the European situation made me too nervous, and I traded in the foreign bond fund for more Treasury Inflation-Protected Securities. (I've written about TIPS often, most recently here.)

All our stocks and bonds are in mutual funds. Moreover, we're never guided by a mutual fund’s past performance; instead, we start by looking for the lowest possible management fees. That's because past performance turns out to be a remarkably unreliable guide to anything that will happen in the future, just like the warning says in every fund's prospectus.

Indeed, one of my favorite economists, Richard Thaler, runs or advises a number of investment funds, including Undiscovered Managers Behavioral Value Fund, which "selects stocks based on recent underperformance relative to the market." In other words, this fund buys the opposite of "performance" — underperformance — on the theory that divergence from long-term trends is often a function of temporary bursts of under- or overenthusiasm. (Thaler, for those who don't know him, is perhaps today's most famous practicing "behavioral economist." Those wishing to see him in action, explaining his field — in a baseball park, as it happens — should click here.)

Which Type of IRA Is Best

You also need to decide which IRA works best for you: Roth or regular?

With a Roth IRA, you pay taxes today (in other words, your contributions are made with after-tax income so there’s no upfront tax deduction) and the money grows tax-free forever. With a regular IRA, you’ll pay taxes on your earnings when you begin to withdraw the money; whether you can deduct contributions to a regular IRA depends on your income and whether you or your spouse contribute to a retirement plan at work.

The key consideration between the two types of IRAs is based on a guess: Will your tax rate be higher when you're older than it is today?

The answer depends on what happens to your income and, of course, what happens to tax rates. If you expect your tax rate will be higher when you’re ready to make withdrawals, you’d be better off with a Roth IRA, since you won’t be taxed on the earnings. Otherwise, a traditional IRA would make more sense.

(MORE: The Pros and Cons of a Roth IRA)

On tax rates, your guess is as good as mine. In the case of your income, your guess is better. But an important reminder in either case: If your assets are growing tax-free, you don't benefit from tax-exempt investments like municipal bonds, so don’t put them in an IRA.

As for names of investment organizations, I have had good experiences with all the ones I've used, including Vanguard, TIAA-CREF, Fidelity and Principal. Vanguard seems to have the lowest management fees and, consequently, most of our money.

The only investment guide I ever felt I needed was Andrew Tobias's The Only Investment Guide You'll Ever Need. But unless Amazon is misinforming me, Andy last updated it in 1999. Still, it's a good place to start and prices for a used copy seem to begin at one penny. Plus shipping, of course.

Your Largest Asset: Human Capital

A more recent book that speaks to your question is Risk Less and Prosper: Your Guide to Safer Investing, by my TIPS guru, Boston University finance professor Zvi Bodie, and financial advisor Rachelle Taqqu. They also wrote an article for The Wall Street Journal in March called "Why Stocks Are Riskier Than You Think" and just responded in the Journal to comments provoked by that piece, including one from a self-described "50-something-year-old" who doubts the wisdom of advising young investors to play it safe.

The essence of their answer echoes something Bodie has said for years: "human capital" is the largest asset most Americans have (simply put, your human capital is your value in the work marketplace).

So if you're an internationally known, tenured professor like he is, you can take plenty of risk, regardless of your age. But if your job future is hazy — and thus your ability to trade on your human capital, iffy — you may want to "risk less and prosper," to the extent you can.

Paul Solman is a member of the Twitterati and can be followed at Twitter@paulsolman. His daily blog can be followed, well, daily at Making Sen$e by linking here or just Googling the words: "Making Sense."