Expert: Paul Henneman - 1/28/2004

Question
I am only 25 years old, married and have a 1 year old child. I am starting to think about retirement preparations already, just so I am ready down the road. I have opened an IRA and have done some research on the web as well as reading from books. My question... With all of this talk about having a diversified portfolio (cash, bonds and stock), I am not sure what is classified as what. This is what I am looking into doing. Saving money into my IRA, which would be the cash part right? Then looking into getting a Mutual Fund from www.ingdirect.com. Now that would be considered stock right? And now I am stuck on the whole bond thing. I know the government sells bonds but what else is there? I was looking into the EE bonds, because it seems like it is a good investment for 30 years from now. Any thoughts? Thanks for taking time to read this.

Answer
Joe,
  Thank you for your question!
  It is good to hear that you are thinking of this now. At 25, you are decades ahead of most people as they think about retirement. The way returns compound over time, this means that you can contribute alot less each month and have many times greater worth when you reach retirement. You are going about this the right way, with concern regarding diversity.
  IRA: an excellent investment strategy. This is an 'individual Retirement Account'. There are several things worthy of immediate note. First, it is likely that your contributions to this are tax decuctible. (there are exceptions to this so check with an accountant regarding your exact circumstances). This is a huge advantage as you will see a big tax benefit. Take the tax refund you get from this and invest further into your portfolio!  Also: IRA's can be invested into just about any investment medium: stocks, bonds, mutual funds, certificates of deposit, annuities, even precious metals. So, the classification question you mention would depend upon how you use the funds in the IRA. Most commonly folks use IRA accounts to invest in stocks, mutual funds, and bonds. The advantage of doing it through the IRA and not directly is the tax benefit. But if you withdraw any funds from the IRA before you are 60, you pay a 10% penalty tax of the amount withdrawn, plus taxes. So only put here what you do not think you will need until retirement, but it is available if there is a true emergency.
   Mutual funds: Yes, do what you can through the IRA. But there are limits to how much you can contribute through the IRA for the tax advantage, you may want to invest more. Don't let the limit stop you, by all means invest directly through www.ingdirect.com or any other service to buy mutual funds. Here is the key: diversify your mutual funds just as you do with your entire portfolio. Do not invest in a single fund, you should over time invest in 3 or 4 funds (or more). Check carefully what the fund tends to hold for their investments. You should pick mutual funds that specialize in different areas such as real estate, health care, energy, technology, etc.  Many folks do not pay attention to this and end up with several mutual funds but find out in tough times that all were heavily invested in technology for example. Then, if hard times hit that industry, the quickly find out out that they were not diversified at all!
   Stocks: About 30% of your portfolio should be in stocks. Again do what you can through the IRA, but if you can invest more than that, do it. You won't get the tax benefit, but the returns over time mean you potentially have a cushy retirement ahead of you. Stocks are more risky, you can lose money at times. Some years will be good, others bad. Over the decades, you can average perhaps 20% at least a year, compared to mutual funds that may get you 12% on average. So stocks are worth the short term risk for the higher long term gains. But with only 30% in stocks, you should never end up in a bad spot.
  Bonds: Unfortunately I cannot be of much help here. This will be the safest type of investment, but also returns the least. My feelings are perhaps 50% in mutual funds, 30% in stocks, and 20% in bonds or money market account, or other very safe investment.
  I hope this helps! Please do not hesitate to follow up with me if I can provide any more specifics, best of luck to you! Successfull investing takes a lifetime of work and learning, you are off to an excellent start.

Sincerely,
Paul Henneman
President
ValuEngine, Inc.
www.ValuEngine.com