Expected Return and Retirement Strategies

Options to Seek Returns with IRAs

All investments consist of two components, which we call principal and interest. The principal is the money we put into the investment ourselves, with the interest or yield being what we have made from the investment, whether this be a negative or positive return.

Traditional IRAs provide potential tax benefits to both the principal and interest side of an IRA, where Roth IRAs only address the interest side. Here, interest refers to any movement in the value of our IRA due to fluctuations in either interest rates if it is in an interest-bearing account or movements in value related to the investment itself where returns are variable.

Expected Return and Retirement StrategiesWhat sort of IRA we end up choosing will depend to a large degree on how well we expect our investments to do, which relates to the type of investing we will be doing. In some cases, depending on the type of investing that we want to do, an IRA may not be suitable at all, for instance very frequent trading is not allowed nor is short selling or trading on margin.

This might appear to only affect actual traders, those in the business of turning over positions very quickly such as a day trader or futures trader does, but these rules also may restrict people who we would consider to be investors as well.

What this does in effect is to limit people to just buying things, and while this may appear to be perfectly fine for the great majority of investors, we may want to consider not exposing ourselves to the risk of down markets while remaining long, which not only adds to our losses but misses out on opportunities to profit from these reductions in asset prices.

There are ways to handle this with an IRA though, which most people aren’t aware of, and present some pretty big opportunities in the right hands.

Managing one’s own positions this way, or managing them in any way beyond just buying and ignoring, is going to require at least some skill though, and this is the real reason why people just invest passively.

While IRA rules do limit what we can do with these accounts, and there are a lot of things we aren’t allowed to do with an IRA account, this doesn’t mean that we are limited to just passive investing.

Timing Markets with IRAs

If people wish to direct their investments more with an IRA, not only are they limited to cash transactions on the long side, in other words betting on the side that the instrument will rise in price, they also need to be aware of the 2 day settlement rule. Whenever we sell a position, and with IRAs this will always involve closing the position and redeeming it for cash, we have to wait 2 days before we can re-invest this money.

When we do not, this is seen as “free riding,” and this is because with many securities, like stocks, we actually don’t get the money from selling them right away. It takes time for the money to be transmitted into our account from the account of the buyer, and we actually do not have the money the day that we sell our position.

Trades are not settled immediately and the trade itself doesn’t get finalized technically on the same day. So, if we look to use the proceeds right away, we actually do not have the money. With a margin account, our broker will lend it to us knowing that our account will receive it soon, but borrowing money simply just isn’t allowed with an IRA, so that’s not permitted.

This means that we won’t be allowed to place trades within this window and this will limit the frequency of any trading that we will be doing with the account, as it really doesn’t make sense to do brief trades if you have to wait two days to redeploy your funds.

This doesn’t mean that we are forced to accept the buy and hold strategy that most investors use, as we can still time our investments and look to be in them when conditions dictate and be in something else or be in cash when things aren’t so favorable.

The idea behind this is to look to improve our returns with our IRAs, and especially to look to improve them over market returns. Depending on the state of the market, we may be well advised to just hold our positions if we’re in a bull market or even in a flat one, but doing this in a bear market will just have us taking losses while it is occurring instead of looking to avoid them.

How Improving Returns Affects our Retirement Plan

With IRAs, and especially with Roth IRAs, better returns mean not only more money in our pockets for retirement, they also mean more tax benefits as well. Presuming that we will enjoy a reduction in tax at retirement with a traditional IRA, both our returns and our principal will enjoy this advantage, and the greater the return, the more we will tend to save in tax.

With a Roth IRA, we save all of the tax that would otherwise be payable on our returns, and this is why a Roth IRA is a much better choice generally for those who seek higher returns than the market. This is only a very small segment of IRA investors though, although there is significant increased potential for returns even if we just ride the bull trends and avoid the bear ones, especially in cases where we get extended bear runs.

People aren’t limited to just trading stocks with an IRA and you can trade just about anything as long as you’re not going short or using borrowed funds, although with some assets such as futures, having to put up a deposit equal to the full amount of the contract just doesn’t make very much sense, as the power of futures lies in the high amount of leverage that we can get with it, otherwise these aren’t very exciting investments at all.

The emergence of exchange traded funds, or ETFs, have opened a big door with IRAs, and it’s not even a matter of being able to trade markets directly such as indexes or precious metals, this all has to do with what is considered to be short positions.

Shorting something involves selling something first and then buying it back later, hopefully at a lower price, and this is the thing that IRAs do not allow. However, if the fund does the shorting, or in reality, tracks derivatives such as futures, where there is really no short selling and the long and short side are equally accessible, then purchasing shares in these funds, called inverse ETFs, are considered to be acceptable.

With inverse ETFs, we’re no longer limited to just taking the long side of an asset, and can also look to profit from decreases in price, the same way short selling does, but without having to borrow the asset.

In the hands of a skilled investor, this can really serve to ramp up one’s returns, because if we’re in a bear market, while traditional investors are seeing their IRAs shrink, ours are growing larger.

It’s actually easier to make money from something going down rather than up, and when we see a trend here, we can either step aside or look to profit from it. As you might imagine, this does require an understanding of how assets move, but if we are willing to learn how to do this, we can really help ourselves in retirement.

We’re not going to be able to shoot for the very high returns that can be gained by very skilled traders, as these returns are driven for the most part by using high amounts of margin, where normal returns are multiplied as much as 20 or 30 times, but we can still well outperform the buy and hold strategy that IRA investors and investors in general typically use.

How Contributions and Return Fit Together

We generally focus on the contribution side of our retirement funds, and for most people, that’s really what they do want to be focused on primarily. A lot of people get a late start on their retirement savings though, and often are not in a position to have much of a chance to achieve their goals even if we stay in a bull market for many years.

There are two components to the ultimate result, and one of them is certainly how much money we invest in our retirement. The other, which is the returns we may expect, is not something that is out of our control, a constant in other words, although we tend to treat it as if it were.

The first step to getting over this is to realize that we aren’t just limited to market returns and aren’t forced to be held captive by bear markets or limitations on growth. We can in fact turn a situation that doesn’t look all that good into one that is much more satisfactory, or take a good situation in retirement and turn it into a better one, by seeking out and achieving higher than market returns.

We’re generally going to want to invest in a Roth IRA if we are looking to do this over a traditional IRA, because the greater the returns, the better a Roth IRA comes out. The reason is that we’re getting full tax relief on the returns with an IRA, in comparison with a traditional one where both our principal and interest is subject to a reduction in tax.

The higher the amount that will receive a full reduction instead of just a partial one, or perhaps no reduction at all if our tax bracket hasn’t changed in retirement, the better it is to apply tax savings directly to the returns.

More conservative investing, for instance with things like bonds or interest-bearing accounts, will tend to favor a traditional IRA, because in the end the ratio of principal to interest will be higher, where with a more active strategy the ratio will be lower than typical.

We also need to look at what our income is expected to be in retirement, and need to make sure that we have a reasonable expectation of tax savings, meaning that our tax rate will need to drop and by more than a couple of percent to ever make sense of a traditional IRA over a Roth one.

In the end, what we put into our IRAs and other retirement savings will always matter a lot, but what we get back will matter a great deal as well, and may even be the bigger of the two amounts depending on our rate of return and how long we’ve been investing for.

Achieving a higher rate of return can be a big boost to how much we end up with, and these earnings can continue well into retirement, and for the rest of our lives actually. A lot of people are very stressed at the prospect of not having enough money to comfortably retire on, wishing that they had contributed more to this, but that’s only one side of the equation.

We should also be wondering about how we may have helped ourselves by managing our retirement investments more actively. In response to expected shortfalls, we usually will just seek to put more into the accounts, but we should also be considering doing more with the money that is already there.

Being able to actually pull this off is certainly not something that is that intuitive and is actually more challenging than people starting out with this realize, but with an appropriate amount of time, effort, and dedication, one can learn to time their investments better and even much better if they really develop these skills and accelerate their expected returns instead of just leaving things up to fate as the vast majority of investors do.

Our retirement money is too important to just do that though, to invest and hope that everything turns out and the market smiles on us enough. This is not the only approach though and IRA rules do allow us to take things into our own hands more and invest more in accordance to market conditions and trends, and if we are successful in doing this, we can really help ourselves achieve our goals more.


Editor, MarketReview.com

Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.

Contact Robert: robert@marketreview.com

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