Roth IRA Index Funds: U.S. stock, bond, and global stock

There are a variety of investment options from which investors can choose in constructing a portfolio for their Roth IRA, a type of tax-advantaged retirement account. Compared to traditional IRAs, a key feature of Roth IRAs is that they are allowed to grow tax-free, although fund contributions are not tax deductible. Upon retirement, investors can make fund withdrawals without paying taxes or penalties as long as they abide by the Roth IRA withdrawal rules. Investors who have reached at least the age of 59.5 and have been contributing to their Roth IRA for more than five years will qualify for tax- and penalty-free withdrawals.

Investors building a Roth IRA to save for retirement will want to design a portfolio using a long-term, buy-and-hold approach. A strong portfolio will be diversified across different asset classes, such as stocks and bonds, and across market sectors. Further diversification can be obtained by investing in assets from different geographic regions. Investors should also focus on minimizing costs because costs are a major factor in determining returns over the long term.

A few core index funds, including exchange-traded funds (ETFs) and conventional mutual funds, may be enough to meet most investors’ diversification needs at minimal cost. On the surface, the tax-efficiency of ETFs may appear to make them a favored fund option since they don’t regularly distribute capital gains. But capital gains are not taxed in a Roth IRA and thus ETFs lose one of their primary advantages over mutual funds. As a result, investors should consider both ETFs and mutual funds when considering investments for their Roth IRA.

U.S. Stock Index Funds

One of the central building blocks of a long-term retirement portfolio is a broad-based U.S. stock index fund, which will serve as the main driver of growth for most investors. Investors can choose either a total market fund or an S&P 500 index fund. U.S. total market funds attempt to replicate the performance of the entire U.S. equity market, including small-cap and mid-cap stocks, whereas an S&P 500 index fund is focused entirely on large caps. The former type of fund is likely to exhibit slightly higher volatility and produce slightly higher returns, but the difference will be fairly minimal over the long term. That’s because even total market funds are generally heavily weighted towards large caps.

Investors may also benefit from the low costs associated with the passive management characteristic of index funds. There is strong evidence that index funds, which attempt to mimic the performance of an index by passively investing in the securities included in the index, generally outperform actively-managed funds over the long term. The main reason for that outperformance is differences in costs. However, there are some investment categories where low-cost active funds tend to outperform passive funds. A passively-managed U.S. stock index fund, when held for the long term, has the potential to benefit from the growth of the U.S. equity market over time. Such a strategy may avoid the significant trading costs of actively-managed funds whose managers often try to time the short-term ups and downs of the market.

A broad-based U.S. stock index fund carries a certain degree of risk, but it also provides investors with fairly strong growth opportunities. It is one of the foundations of a long-term retirement account. However, for those with a very low risk tolerance or who are approaching the age of retirement, a more income-oriented portfolio may be a better option.

U.S. Bond Index Funds

Adding a U.S. bond index fund to an investment portfolio helps to reduce the portfolio’s overall risk. Bonds and other debt securities offer investors more stable and secure sources of income compared to stocks, but they tend to generate lower returns. An inexpensive bond fund that tracks a U.S. aggregate bond index is ideal for providing investors with broad exposure to this less-risky asset class. An aggregate bond index typically provides exposure to Treasurys, corporate bonds, and other types of debt securities. Investors seeking to construct a long-term retirement portfolio will want to have exposure to both stocks and bonds, which they can achieve through a single stock index fund and a single bond index fund. The exact proportion of stocks to bonds will depend on two primary factors: how close the investor is to the age of retirement and how risk averse they are.

The traditional investing approach has called for a 60/40 portfolio—60% stocks and 40% bonds—will satisfy the needs of most investors, and that the proportion of stocks relative to bonds should shrink as the investor ages. Another traditional yardstick has been “100 minus your age.” This means that a 30-year old should hold 70% stocks and 30% bonds, and by age 40 they should have the 60/40 portfolio. But that approach has changed for many financial advisors and prominent investors, including Warren Buffett. Many financial experts today recommend holding a higher percentage of stocks, especially as people are living longer and thus are more likely to outlive their retirement savings. Investors should always consider their own financial situation and risk appetite before making any investment decision.

A broad-based U.S. bond or fixed-income fund is generally less risky than an equity fund. However, bond funds don’t provide the same growth potential, which means generally lower returns. They can be useful tools both for risk-average investors and as part of a portfolio diversification strategy.

Global Stock Index Funds

Investors can diversify their portfolios further by adding a global stock index fund that holds a broad selection of non-U.S. stocks. A long-term portfolio that includes a global stock index fund provides exposure to the broader world economy and lessens the exposure to the U.S. economy in particular. Inexpensive funds that track an index like the MSCI ACWI EX-U.S. or the EAFE Index provide broad geographical diversification at a relatively low cost.

Investors with a greater degree of risk tolerance may choose to invest in an international index fund with a particular focus on emerging market economies. Emerging market countries, such as China, Mexico, and Brazil, may exhibit higher, but more volatile economic growth than the economies of developed countries, such as France or Germany. Though it’s also riskier, a portfolio with greater exposure to emerging markets has traditionally yielded higher returns than a portfolio that’s more focused on developed markets. However, emerging markets have been facing especially heightened risks amid the ongoing COVID-19 pandemic.

Consistent with modern portfolio theory, risk-averse investors will find that investing in a broad-based U.S. stock index fund and a broad-based U.S. bond index fund provides a significant degree of diversification. Furthermore, the combination of a U.S. stock index fund, a U.S. bond index fund, and a global stock index fund provides an even greater degree of diversification. Such an approach has the potential to maximize returns over the long term while minimizing risks.

The Bottom Line

Investors looking to save for retirement with a Roth IRA will want to focus on the long term, and choose investments that are inexpensive and provide significant diversification. One of the simplest ways is by investing in a few core index funds. Ideally, a strong portfolio will contain a single U.S. stock index fund, which provides broad exposure to U.S. economic growth, and a single U.S. bond index fund, which provides exposure to relatively-safer income-generating assets. For added diversification, investors should consider a global stock index fund, which provides exposure to a broad range of developed and emerging markets.