Risks in Roth IRAs?

[Guest Tami]

I'm a 23year-old college student who thought a Roth IRA was a good idea. When my bank mentioned "risk tolereance" though, I started getting nervous. Does anyone know of a website that explains how an IRA works in general? I'm really new at this, and I'd like to get an idea of what risks I'm taking. Honestly, I had no idea that risks were involved.

Thank you,

Tami

[Michael Devault]

You might take a look at http://www.rothira.com for information on Roth IRAs.

The person at the bank, when mentioning risk tolerance, was likely trying to get a feel for the type of investment that would be most suitable for you. You can invest your contributions to a Roth IRA in bank savings accounts, annuities, mutual funds, etc. Each has its own risk/reward ratio. With some, you have no fear of losing your principal, but the return on those types of investments generally is lower. With others, while you risk the loss of principal, the return is higher. There is a wide range of investment choices... the bank is trying to find a proper fit for you.

Hope this helps. Good luck! And, congratulations on deciding to start saving early for your future.

[John G]

Relax. Everything in life has risks... driving a car, working, playing golf (lightning!, getting hit by a ball), not studying hard (added in case my daughter is reading this!), using appliances, getting a suntan, etc. As an adult, you need to understand your risks and respond. Same with investments.

All types of investments have some level of risk. Even doing nothing with your money involves risk. For example, if you bury your money in the yard you run the risk that it rots away, your neighbor digs it up, you forget where it is, and most important of all you lose ground every year to inflation. Erosion of value from inflation is the fundamental reason why we are compelled to do something with our money.

Lets look at Bank CD risk. They are ussually insured against bank failure. The risk is therefore less an issue of loss than that your return does not exceed inflation. The yield on a CD is ussually fixed and the term ussually fixed so you know in advance what you will finally receive. You have an "opportunity cost" when compared with a different investment with a better return, such as a corporate bond or stock. You make the choice based upon your perception of risk. Are you concerned that the economy and stock market will go kaput (a technical term) or concerned that your investment will not grow suffiently for your later needs.... in this case retirement.

Lets look at stocks. If you own just one, then the obvious risk is that you could make a bad pick such as a company that performs poorly. But if you own a diverse group of stocks such as through a mutual fund, your primary risk is the market is weak during your holding period. Historically, the longer you hold an investment, the lower this risk becomes. For example, over the last 70 or so years there has not been a single 20 year period (N=50 observations) where the market has ended lower. The average annual return has been in the 11-13% range for equities. But in 40 years, you are sure to have a bad year with a negative 20 to 40%. And the best years maybe you have a 40 to 60% gain. Fortunately, the good years have outnumber the bad years by more than 5 to 1. Why this is true is complicated but I guess the simple answer is that in the long run our economy has grown. No guarentees in any one year. Equities are a pretty reasonable choice for the long term. And no one can tell you for sure which are the good years to come and which will be down! No one. So don't ask me or anyone else.

If you are young and a long term investor, you should have no fear of equities (aka stocks). Since you are 23, you may be investing for more than 4 decades. Probably more like 6 decades since you don't stop investing the day you retire either. When you understand investing, you will better accept the idea that you sometimes will have a bad year.

The bank was asking you how much risk do you want to take. It is a prudent question for them to ask. They are trying to find out what kind of investor you are. For example, the internet IPO investors are more like folks who go to the track and bet all day on long shots. A cautious investor spreads out his stock choices such as through a mutual fund or a modest portfolio of individual companies. That reduces the risk. This later type of investor is like the old Notre Dame football teams, grind it out on the ground each down for four yards and you will move down the field. An investor scores TDs when they invest for the long term and make reasonable choices amongs stocks and bonds.

You need to become more educated about IRAs and investing. Read Kiplinger Financial or Money mags. Besides banks, call some brokerages such as Schwab, Etrade, Fidelity and ask them for their IRA start kit. Let them know you are a novice. They have info to help. You can find phone numbers in the mags and on the internet.

Get started and treat the first few years as the big experiment. Don't worry so much about your return, but rather focus on what you will learn. Suscribe to a couple of the above mags. Read 1-2 hrs a month and you will be on your way.

Want to decrease you stock market risk further? Then put your funds in the broadest and lowest cost mutual funds, an S&P500 index fund or Wilshire 5000 fund. Choose a no-load fund (no commissions) with someone like Vanguard (a mutual fund company). You then indirectly "own" 500 or 5000 different companies. That gives you "diversity" which means a spreading out of risk amongst many investments. Good luck.

Got more Qs? Post again or email me.

[Edited by John G on 08-30-2000 at 01:43 AM]