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In the previous article, I explained How to Start Investing with an IRA. That article covered which kind of IRA to open (Roth IRA), where to go for your IRA (Fidelity, Schwab or Vanguard) and how to fund your IRA (from your checking account by electronic funds transfer), and where to park your money (money market mutual fund) until you decide what you want invest in.

This article assumes that you followed the suggestions in that article and you now have $5000 sitting in Vanguard’s Prime Money Market Fund (Ticker Symbol: VMMXX) in your Roth IRA at Vanguard. If you went with Fidelity or Schwab, they have similar funds as does Vanguard, so only the details change. The basic ideas apply.

Where To Put $5000 in IRA?
There answer to this depends on your financial situation like your age, health, net worth, how much debt you have, and so forth. In other words, everybody is not the same so we need a profile for the investor.

Let’s say you are an unmarried, 25-year-old college graduate who moved to Los Angeles to follow a talent career in the movie industry. You have a good day job that earns roughly $40,000 per year which provides decent benefits like health insurance. Your rent is $1,000 per month. Your other assets are $8,000 emergency fund in your credit union savings account and a 2005 Toyota Corolla with 75,000 miles on it. You expect to retire in 40 years at age 65 in the year 2050.

In the article, What is Saving & Investment, I explained that the two main investments are bonds and stocks. Bonds are a loan to a company or the government which pays interest. Stocks, or equities, are partial ownership in a company which pays dividends. (Equity is a term from accounting, and is just a fancy way to say stocks. Sometimes people us the word shares instead of stock.) So your $5000 IRA contribution will go into stocks and bonds.

The Main Decision: Stock/Bond Mix
The main decision you have make is how to split or allocate your money between stocks and bonds. This decision is called your asset allocation, or stock/bond mix. The most common way to express your asset allocation is in percentage terms. If you put half in stocks and half in bonds, we would say your asset allocation is 50/50. If you put 75% in stocks and the rest in bonds, we would write 75/25. Usually the stock allocation is written first, as in stocks/bonds.

Remember from that article, stocks are more risky than bonds because bonds are required to pay interest and return your principle to you at maturity, whereas stocks have no requirement to pay dividends and there is no maturity date. If you want to take your money out of stocks, all you can do is sell it to someone else. If prices are unfavorable at the time, you lose money.

Well, you may ask, if stocks are riskier than bonds why put any money at all into stocks? The answer is that most investors believe that in the long run the United States will prosper, the national economy will grow, businesses will see increasing sales and higher profits, and be able to pay higher dividends. In short, investors are counting on future prosperity and so they expect stocks to have a higher return than bonds.

Higher Return Always Means Higher Risk
This is a fundamental principle in investing. If there are two investments A and B, and A is more risky than B, then investors should demand a higher return from A. The risk is that the expected higher return will not materialize.

Here is an example. Suppose investors have a choice between investing $5000 in Stock A or Bond B. You expect Stock A to return 10% per year over ten years, but the return is uncertain. Bond B is a U.S. Treasury that is guaranteed to return 5% per year over ten years. There is no uncertainty that you will receive your interest and principles at the end.

If you go with Bond B you know what you are getting, i.e. 5% per year for ten years. Suppose instead you decide to go with Stock A, which you expect to return 10%. Ten years pass. Your actual return is 0%. There is a lesson: with risky investments the actual returns does not equal the expected return. This is what stock investors experienced from 1999 to 2009. As Homer Simpson would say, “D’oh!”

You can not get a higher return without taking on more risk, or as some people like to say “there is no free lunch.” (BTW, the converse is not true. Just because something is high doesn’t mean it has has high expected returns. There are lots of things that are high risk with zero or negative expected return. An example would be playing roulette in a casino.)

How Risky Do You Want To Go?
So your important asset allocation decision boils down to how much risk are you willing to take. Here are simple rules of thumb.

BONDS: If you buy an insured 1-Year CD there is no risk. You will get all your money back, plus interest, after one year. The same is true with U.S. Treasuries. You get all your money back at maturity.

STOCKS: It is not uncommon for the average stock to fall 50% during a bear market. In fact it has happened frequently enough in the past that a 50% drop should be expected as routine. There is the possibility for stocks to fall even further, say by 75% or 90%. Many individual stocks have lost 100% during economic crises. In other words, a total loss, like burning money in the fireplace. Just Google Enron, WorldCom or a dozens of others.

Using these rules of thumb, Table 1 shows the risk of loss at various mixes of stocks/bonds:

Final Answer
I  suggest keeping your $5000 IRA contribution in the Vanguard Prime Money Market Fund for a bit longer while you think about how much loss you are willing to tolerate. What’s the rush? Your retirement is not for another 40 years.