You hear it all the time. Save for retirement!

Many financial experts — including my favorite, Suze Orman — tell you to contribute to a Roth IRA or traditional IRA outside of your 401(k) plan. But once people hear this advice, many draw a blank on what contributing to an IRA or Roth IRA really means.

#-ad_banner-#I’ve spoken to dozens of people about this topic and many seem to view a traditional or Roth IRA as a savings account that you simply deposit cash into.

But that’s not the case. IRAs and Roth IRAs aren’t simple deposit accounts, but rather tax-sheltered accounts designed to hold investments — investments that you’ll need to choose wisely if you want to grow your nest egg in a meaningful way.
 
If you open a Roth or traditional IRA account with a bank that posts a set annual return rate with the retirement account, the money is generally invested in CDs or money-market accounts within the bank (which deliver about 1% to 2% annual returns). This works fine for older people who already have most of their retirement funds saved up and don’t want to risk losing their hard-earned money.

However, if retirement is more than five years down the road and you want inflation-beating returns, then you’ll need to open your retirement account with a brokerage firm. Once your IRA is open, you can load it up with more aggressive instruments including stocks, bonds and real state investment trusts (REITs).

Using the guide below, you could potentially start your retirement plan over your lunch break today using just an online broker and $100.

Open your retirement account with an online brokerage firm

Pick an inexpensive, online brokerage firm to open your Roth IRA or Traditional IRA. Each online broker is different, so be sure to consider all maintenance fees, trade commissions, minimum balance requirements and other fees before making your selection.

If you’re starting with $100, then consider opening a Roth IRA or Traditional IRA using Sharebuilder.com, Scottrade.com, or E*Trade.com which don’t have a minimum balance requirement for retirement plans and charge commissions from $10 (E*Trade) to as low as $4 per trade (Sharebuilder).

Find the right portfolio allocation

Before you start trading in your newly-opened retirement account, you’ll need to decide which investment mix is best for you to maximize returns and minimize risk. But remember, one portfolio allocation model does not fit all.

For some guidance, financial experts Daniel C. Goldie (CFA, CFP) and Gordon S. Murray laid out three portfolio allocation models in their book, The Investment Answer.

As you can see, the S&P 500 delivered a respectable 9.5% annualized return during the 37-year period between 1973 and 2009. However, you can also see the benefits of investing outside just the S&P 500: Even the most conservative portfolio beat the S&P 500 performance in the long run.

And much to my own surprise, the most aggressive portfolio model, with all its small-cap stocks and international stocks, had a significantly lower standard deviation (had less severe ups and downs over the years) than the tried-and-true S&P 500.

If you originally invested $10,000 in one of these portfolios in 1973, then it would have grown to a balance between $369,000 (Conservative Model) and $788,000 (Aggressive Model) by the end of 2009.

The authors explain this simple, yet important tenet of diversified investing: “Focus on the performance as a whole, rather than the returns of its individual components.”

Because every investor is a different age and has a different stomach for risk tolerance, these models won’t suit everyone. To develop your ideal portfolio, you should consider further reading on investment allocation or consult with a professional before you start trading.

Use index-tracking exchange-traded funds (ETFs) to create your own diversified portfolio

By investing in index-tracking ETFs that follow five major asset classes, you can easily create your own retirement portfolio that mimics one of the allocation models shown above, without having to buy dozens of stocks, individual bonds, or any physical land.

The five major asset classes in Goldie and Murray’s model portfolios are: U.S. stocks, foreign stocks, real estate, bonds and cash.

Your brokerage firm will automatically move any unspent funds in your portfolio into a money market account, so you don’t need to worry about cash. These four inexpensive, index-tracking ETFs cover the four other major asset classes:

 

By using one of the allocation models shown in the last section as a rough guide (or use a financial advisor to guide you), you can invest monthly in these ETFs to build your portfolio over time.

Action to Take –> Combined to make up your simple retirement portfolio, these index-tracking ETFs offer diversity that will carry you through periods of inflation and market downturn without sacrificing performance over the long-term.