This is the first of what is planned to be 100 articles on mistakes Rookie IRA Investors make. All of them have been carefully trialed and found to lose money for Rookies, though some of them are more effective than others.
Before we start, we need to define what I mean by a Rookie IRA investor, because this term could be defined from various different perspectives.
There are a number of ways you can get funds into an IRA account. First of all you need to open an IRA account with a brokerage company.
There are various types of IRAs, chiefly a traditional IRA is one in which you may deposit up to $5000 each tax year, slightly more if you are close to retirement age, and you can claim this contribution as a tax deduction each year to increase the amount of your refund or reduce what you owe.
Alternatively you may open a ROTH IRA which is an account into which you deposit post-tax earnings and don't get a deduction. The difference is that with a traditional IRA account you may grow your investments without paying tax on any transactions within your account, but when you make withdrawals in retirement, the whole amount becomes part of your taxable income. With a ROTH IRA, you don't pay any tax on transactions within your account, but you don't have to pay any tax on retirement withdrawals either.
Which is best? I would say that in theory the ROTH is better, because by waiving a relatively small tax deduction each year, you gain hugely in retirement after your investments have earned much more money for you. On the other hand the reality is that if you don't get that extra refund in your working years, you may not have enough cash to fully fund your IRA, or the news that there will be no vacation this year may not be well received by your family, and you may even incur extra expenses for a visit to the Emergency Room.
However there is a third kind of IRA that may be of interest to many Seeking Alpha readers of the baby boom generation, and this is the so-called Rollover IRA, which is what I have, and what I will be writing about in forthcoming articles. A Rollover IRA is actually a traditional, or regular IRA, but one that has been augmented or consists solely of funds "rolled over" from an employer's pension plan.
In my case, when I retired from working for the state government, I was able to choose between a monthly sum with a cost of living allowance to be paid each month until I died, or a lump sum that would be rolled over into an IRA account for me to manage and withdraw funds as I pleased. I chose the latter. In this manner it is quite possible for individuals who have little experience of investing to suddenly find themselves at the helm of a fund of a few hundred thousand dollars and launching forth into the wonderful world of stocks and options without the faintest idea of what to do next.
This was the situation I found myself it, so naturally my first move was to be sensible and conservative and buy large amounts of a nice stable dividend-paying stock to provide me with income on my capital. Good move?
No, because a Rookie does not have faintest idea how to build a position in a stock. The first mistake a Rookie IRA Investor makes is to buy a block of stock all in one go, so as to get his cash deployed. He plonks down $45,000 of his extremely hard-earned money to buy 1000 shares in a stock like BP (NYSE:BP) in July 2011, and in August he checks his account balance only to find that he holds not much over $35,000 of the stock. Of course the dividend is a great consolation and even if the stock never recovers, he should be back to square one in less than 20 years, but seeing the error of his ways he decides to sell the stock for $35 to cut his losses, only to see BP rebound past the $40 mark very quickly the following month.
The large monthly candlesticks for BP from August to September, 2011 are shown in the middle of the chart below.
Oh how he wishes he had bought those shares for $35 each instead of selling them for $35 each and a loss of $10,000 within a month. He could have bought them for $35 each and sold them for $45 each the next month if he had played his cards differently.
At this rate his retirement will be over in a year or two and instead of lounging in the shade of a palm tree trading stocks on a tropical beach, he will pass his golden years marshaling supermarket carts in an asphalt parking lot under a tropical sun.
OK, readers, this is not a precise example from real life, but a little hyperbole never hurts when you are trying to make a point, and probably everyone has made this kind of error of buying a full position in a stock at market price, if only on a smaller scale.
Part Two of this article will continue to discuss what a Rookie IRA Investor might have done differently to ease into a position in BP over a period of time at the lowest possible basis and position himself to collect dividends for years to come and not have to push a supermarket cart except when making purchases.
Disclosure: I am long BP.