The Best Way to Invest Money In IRAs

Smart IRA investing can produce a growing nest egg that allows you to sleep well at night. Photo: via flickr.

An IRA can be a great tool when trying to save for retirement, with excellent tax advantages and the freedom to choose virtually any stock, bond, or mutual fund you want. But because this "freedom" can seem overwhelming to beginning investors, here's a guide to help you figure out which investments belong in your IRA.

How much in stocks and how much in bonds?When investing for retirement, you should use a mix of stocks and bonds in your portfolio. Bonds give you the safety of a fixed-income stream, while stocks can produce growth in addition to quarterly dividends.

A general rule is that when you're young, you have the time to ride out the ups and downs of the stock market, so you can allocate more of your portfolio to stocks and (hopefully) produce strong long-term growth. Then, as you get older, you gradually shift more of your money into bonds, as stable income becomes the focus, rather than growth.

A good rule of thumb is to subtract your age from 110 to determine the percentage of your portfolio that should be in stocks. So, 40-year-olds should have roughly 70% of their retirement savings in stocks and 30% in bonds.

Stocks shouldn't ever disappear completely -- unless you're more than 110 years old, according to my formula. There's always some room for stocks in your portfolio, but you should definitely get more conservative with age.

Past performance doesn't guarantee future results, but...When I talk about stocks, there are only certain types that, in my opinion, belong in your IRA. If you like adventurous and speculative stocks like Teslaor Netflix, great. Just don't invest in them with money you can't afford to lose, and the money in your IRA definitely fits into that category.

Instead, focus on solid, established companies with a strong track record of revenue growth and dividend increases. As one example, the "dividend aristocrats" are a group of companies that have all increased their dividends for at least 25 years in a row. And while there is no guarantee that they will continue to do so in the future, many of these companies are among the most consistent performers over the long run..

Here are a few examples of dividend aristocrats that work great in an IRA:

All calculations performed using data from 4/28/95-4/28/15. Assumes reinvestment of all dividends.

Rules for evaluating an "IRA stock"Of course, the dividend aristocrats are not the only excellent IRA investments. For example, I think that Berkshire Hathawayis one of the best retirement stocks you can buy, even though it has never paid a dividend. It has, however, maintained a record of fantastic management and has produced great returns for its shareholders through other means.

Basically, when evaluating stocks, there are a few questions you should ask yourself:

  • Does the company have a good record of performance and profitability, especially during recessions?
  • Does the company have an acceptable debt level?
  • Does the company have a good record of returning capital to shareholders, either through dividends or share buybacks?
  • Most importantly, does the company have a competitive advantage such as a strong brand name, superior products, or a unique business model, that will allow it to make money for the next several decades, no matter what?

For a stock to be a good IRA investment, the answers to all of these questions should be an easy "yes."

Don't want to do a lot of homework? That's OK, too.If picking individual stocks doesn't sound like fun to you, that's completely fine. There is a type of investment you can buy called an index fund, that allows you to get the stock exposure you need without the homework involved with choosing individual companies to invest in.

An index fund is either a mutual fund or ETF (exchange-traded fund) that tracks the performance of a certain group of stocks-either a certain sector or a certain market index like the S&P 500. For example, the Vanguard S&P 500 ETFinvests its money proportionally in the 500 stocks that make up the index, with the goal of matching its performance. Or, the Financial Select Sector SPDRtracks the overall performance of the the financial sector, with the largest companies weighted the heaviest.

There are index funds that focus on all different types of stocks (small cap, large cap, foreign, domestic), and all different sectors of the market, so you can invest in virtually any type of stocks that you want. For instance, if you have a high opinion of the health care sector in general, you can put your money into a health care index fund that will allow you to benefit from the sector's overall performance, without being too reliant on any one company.

For a more complete introduction to index fund investing and some ideas to get you started, check out this other article I wrote.

The Foolish bottom lineWhile you definitely want to invest conservatively in your IRA, that doesn't mean you can't build a portfolio that will grow into a large retirement nest egg and eventually produce a reliable income stream that will last as long as you do.

Through smart stock-picking methods, index fund investing, and a good asset allocation strategy, you can create a well-diversified portfolio that has the potential to deliver excellent returns over the long term while allowing you to sleep soundly at night knowing your money is safe.

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Matthew Frankel owns shares of Berkshire Hathaway. The Motley Fool recommends 3M, Aflac, Berkshire Hathaway, Netflix, and Tesla Motors. The Motley Fool owns shares of Berkshire Hathaway, Netflix, and Tesla Motors. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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