Starting Up A Roth IRA

A friend of mine who is 24 years old and still only a couple years out of college recently made an excellent decision to open up a Roth IRA at TDAmeritrade.

He'd read a bunch articles describing Roth IRAs (rothira.com), he looked at the tradeoffs between investing in traditional vs. Roth IRAs, he asked me some questions about where I thought social security was going to be when he retired in 2047 (don't count on anything, I told him) and most importantly, he found a bunch of retirement savings calculators through Google and saw how much his savings could grow over time if he started today.

He funded his account with $500 (it still counts as a 2006 contribution since he's doing it early in 2007), and the next question he had was: what the hell do I do now? He logged onto TDAmeritrade's site, but being an investment newbie, he had no idea what any of the words meant, and no idea where to go from there.

So I gave him some advice that I would give to anyone in his situation.

First of all, I told him that his money was currently sitting in a money market fund at TD Ameritrade, so even though it isn't earning him much, he can take his time figuring out where to go from there and not feel like he has cash rotting idly away.

He asked me if he could put it in an investment that was guaranteed not to lose any value. I told him he could find something similar to that, but that nothing could ever really have such a guarantee attached to it.

I also told him that, given his 40 year time horizon, he could afford to take on more risk and most likely earn much higher returns over the long run. I recommended he use his $500 to buy shares of an Index Fund, particularly, an S&P 500 Index Fund and even more particularly, the Vanguard S&P 500 Index Fund. I felt that an individual stock would be too risky for him, since neither of us have been following individual stocks lately, and I felt that an actively-managed mutual fund would more likely than not underperform the S&P 500 over the next 40 years, and charge him high fees in addition to all of that.

Before I suggested he log on and make the trade, I asked him another question: are you planning to put any more money in soon? He said he would be able to put another $500-1000 in sometime over the next couple of weeks. As a result, I recommended he wait until he put that next deposit in, then buy the fund shares using a single trade. TDAmeritrade charges $10 for Internet equity trades, and given the relatively modest sum he was talking about, it was worth saving the extra transaction fee.

So that's where he's going to go. Over the next few years, I think he is going to educate himself a lot more about investing, and I'm going to recommend he add some other asset classes to his Roth IRA portfolio, in particular small-cap funds (I am a big fan of Dimensional Fund Advisors index funds in this category) and international funds. I am going to recommend he set target weights, stick to these over time, and strive to keep costs down wherever possible.

When he gets more steady employment (he currently works without benefits), I'm going to recommend that he participate in his employer's 401(k) program, if it gets offered to him, and that he do this via automatic deductions from his paycheck.

I'm also going to give him my copy of The Motley Fool Investment Guide : How The Fool Beats Wall Streets Wise Men And How You Can Too, which is an easy read investment primer. If it interests him, I have a library full of books he can use to explore from there.

The most important point I wanted to get across to him was that investing isn't some kind of black magic. It is something anybody can learn, and, given the right set of expectations (that stocks will perform better than the alternatives over the long run, offering returns somewhere in the neighborhood of 10% per year), it is something anybody can excel at.