There is no average return for an individual retirement account because returns are based on a wide variety of factors that are unique to each individual IRA account. What's important is that IRAs offer individuals a way to deduct funds from taxable income and generate tax-deferred -- or even tax-free -- returns. Because of these multiple benefits, it is recommended that you take the maximum allowed deductions for IRA accounts. Asset allocation decisions drive IRA performance, because returns within asset classes are relatively homogeneous, especially if you diversify your holdings, as recommended.
You can invest in two types of IRA accounts -- Roth IRAs and the traditional IRA. Roth IRAs generally offer better tax savings, but they are contingent on a number of factors, including your eligibility to make contributions to the accounts based on your income. The main benefit of Roth IRAs is that they allow you to make tax-free withdrawals, whereas traditional IRA contributions are tax deferred. You pay taxes on withdrawals from traditional IRA accounts. Another difference between the two IRAs is that they have different age requirements for making withdrawals without drawing any penalties.
Your asset allocation decisions will be among the greatest drivers of your IRA returns. This is because returns within asset classes tend to be relatively homogeneous. Also, you should invest in a diversified portfolio of assets both within an asset class and among asset classes. This means that if you invest in stocks, your returns should closely approximate the returns of the overall stock market. Because of this, it makes sense to invest in low-cost exchange-traded funds that precisely replicate market returns.
One of the best proxies for future returns are long-term historical returns. We know, from looking at stock returns going back to 1926, that stocks always generate positive returns in the long term. Small stocks generate higher returns than larger stocks. This phenomena is known as the small-stock premium, but you also assume more risk by investing in small stocks.
You should focus on maximizing risk-adjusted returns, which means optimizing each unit of return relative to its related measure of risk relative to the market. In the most general sense, this is done by maximizing the benefits associated with diversification. One of the most commonly used measures of risk-adjusted returns is the Sharpe ratio. Sharpe ratios are frequently disclosed in fund prospectuses. It is calculated by dividing a security's equity risk premium by its standard deviation. Equity risk premium is calculated by subtracting the broader market's expected return from that of a particular security.
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