My IRA had half the return of my other investments… and that's okay!

Jan 29, 2011 by

On New Year’s Day, I calculated the rate of return of both my regular investing portfolio and my Roth IRA. I found that I’d had twice the rate of return in my regular account than in my IRA. Normally, people would be upset if one of their accounts had a lower rate of return than another. However, in this case, the difference is actually okay by me, as it is a result of how I constructed the two portfolios.

Why are the two portfolios different?

I can pour as much money as I want into my regular portfolio, whenever I want. However, I my Roth IRA restricts both the amount of money I can contribute and when I can contribute it. Due to these artificial rules, money in the Roth IRA is more irreplaceable than money in the regular investing account. While I could take an extra job to replace money in the regular investing account, after making maximum annual contributions to the Roth IRA, the only way that I can add more money is to wait. Sure, I could put more money in my regular investing account, but that money will be subject to capital gains taxes when I withdraw it, whether I am elderly or not. As a result of this difference, I constructed a less risky portfolio for my IRA.

How are the two portfolios different?

The IRA portfolio contains stocks that have lower variance in returns, but also lower expected returns, than the stocks in the regular portfolio. That is, the stocks in the IRA portfolio are both unlikely to do fabulously well and unlikely to do horribly. Many of them are ETFs (Exchange Traded Funds) that are comprised of a large number of different stocks. All of this diversification reduces both the variance of the return and the rate of return.

Meanwhile, the regular portfolio contains many stocks corresponding to actual companies. Many of the stocks in the portfolio are Pink Sheets – stocks of small, often foreign companies priced at $5 or less. As these companies are of smaller size and importance than companies that mainstream focuses its attention on, there is far less information available about their performance. Fewer analysts follow them, and they are less likely to release detailed financial statements, especially if they are listed abroad. To reduce the risk that any individual Pink Sheet company will perform horribly, I own small quantities of a large number of Pink Sheets. This strategy is riskier than the strategy that I employ with my IRA, as there is a far higher chance that any of the individual stocks will lose substantial value. Also, small dollar changes result in huge percentage swings, as the stocks have such low values to begin with. (For instance, a $1.00 stock that rises to $1.10 has gained 10%. That’s the same change as a $100 stock rising to $110. As an investor, the price of a stock is irrelevant, as it is the proportion of the change, not the amount that matters.) Thus, my substantial Pink Sheet investing in my regular portfolio yields both greater risks and greater rewards.

To conclude, with every portfolio, it is essential to assess both your needs and your risk tolerance. One person may have different risk tolerances in different contexts.

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