In the current economic climate, it can be a real challenge to come up with a solid investment strategy. With government policies seeming to change daily, like the fate of the Bush tax cuts and the Federal Funds Rate, personal economies have become much less stable.

Add economic uncertainty and market volatility to the mix and it can become almost intimidating to figure out the most stable, and lucrative, investing strategy. So what is the best way to plan for your future during these uncertain times? It’s important to learn how to alleviate the effects governmental changes and economic fluctuations could have on your investments.

The Importance of Diversification When Investing

The key to smart investing all comes down to one word: diversification. This is a good strategy to have regardless of the state of the economy. However, considering the ever-changing tax code, the possibility of further tax hikes, and markets that have no consistent trends, it’s now especially critical to spread your money around in various assets.

You may already know that it’s never a good idea to have all your eggs in one basket, but how do you decide where to put your money? Here are several of the options you might choose for your investment and retirement savings, and how they could shield you from potential problems in an uncertain future:

1. 401k and Traditional IRA

The traditional versions of individual retirement accounts (IRAs) and 401k plans are great investment vehicles. Both are funded with pre-tax dollars; then, upon withdrawal, the funds are taxed at your normal income tax rates.

While these accounts have definite perks, there are a few drawbacks to consider as well.

• Withdrawals Are Taxed. If tax rates increase between the time you invest and the time you withdraw, you’ll be liable to pay more in taxes upon withdrawal. Therefore, your funds will be at the mercy of any government tax hikes. For example, let’s say you have $40,000 in one or both of these accounts and you’re ready to withdraw funds. If, for some reason, the government decides to bump the tax rates by a mere 2%, you’d be paying an additional $800 in taxes. If you had more than that invested, the difference would be even greater.
• Limits and Penalties Apply. Both of these accounts have annual contribution limits and early withdrawal penalties. As a result, you have less control over how much you contribute, and no easy access to withdraw funds without losing money.

With that said, these can be great options for people who don’t really want to play the investing game. Since the money is taken from your check pretax, it can help to lower your income tax bracket. Plus, those fees and penalties may seem like a pain, but at least they’ll keep you from dipping into your retirement fund. Most importantly, I want to stress that if your company offers a 401k match, you should absolutely take advantage of it! There is nothing like free money.

2. Roth 401k and Roth IRA

If the drawbacks associated with a typical IRA and 401k accounts concern you, the Roth versions of these investments may be more appealing. These accounts have two key differences from the regular versions:

• Immunity to Taxes. These accounts are funded with after-tax dollars and any funds withdrawn will thus be tax-free. As a result, investments made in a Roth account are immune to whatever tax rate hikes may occur. In addition, if you experience large capital gains in these accounts, all of these gains will be 100% tax free, a huge advantage over the non-Roth counterparts.
• Lower Contribution Limits. While these accounts also have 401k and Roth IRA contribution limits, the Roth versions have significantly lower limits than the 401k and traditional IRA.

3. Individual Stocks or Bonds

Investing in individual stocks or bonds carries several advantages:

• There is no limit as to how much you can “contribute” to them.
• They don’t carry the same management expenses associated with stock or bond funds.
• You can withdraw (or sell) at any time without having to wait until you reach retirement age.
• If you hold onto either investment for more than one year, you can avoid hefty taxes by qualifying for the long-term capital gains tax rate.

Perhaps one of the biggest advantages is the number of ways you can diversify within these investment types themselves. Here’s how:

1. Allocate your funds across various sectors. That way, should any one industry experience a downturn, your portfolio will not be overly exposed to the consequences. You may even experience a gain in another industry at the same time, in turn balancing out the loss.
2. Tailor your investments based on your concerns. For example, if you’re specifically worried about the potential for inflation, focus your stock and bond investments on commodities, since these will generally increase with inflation. As an added precaution, you can also choose to invest in Treasury Inflation-Protected Securities (TIPS), which are designed to pay you more money if inflation takes hold of the economy.

More adventurous investors can choose to allocate a small portion of their portfolios toward financial derivatives, including put and call stock options. However, keep in mind that these are perhaps the most volatile investments you can make, so tread with caution and only do so if you are an advanced investor.

4. Stock or Bond Funds

If you aren’t an experienced investor, it may be worth it to invest in a stock, bond, or mutual fund, despite some of the fees involved. Generally, these funds are designed by sophisticated managers, and are targeted towards specific investment styles. No matter what your expected retirement age and risk appetite, you should be able to find a fund that suits your needs.

5. Invest Internationally

Another way to diversify your portfolio that I find particularly attractive is to invest internationally, regardless of what investment vehicle you have in mind. Personally, I have nearly one-quarter of my investment dollars invested overseas.

Investing at least some of your money internationally will free up your portfolio so that it is not completely reliant on the successes (or failures) of the U.S. economy. And if the dollar ever goes into a downfall, this portion of your portfolio may actually benefit.

6. Save as Much as You Can

Finally, perhaps the most reliable way to shield yourself from all of the current economic uncertainty is to simply save as much as you can. By increasing the size of your nest egg, you’ll be positioning yourself even more favorably to deal with any economic calamity, or government changes in policy that may occur moving forward.

Focus on developing your emergency fund and creating as much passive income as you can. Saving money in these tough economic times can seem a bit challenging, but I can assure you that you’ll be glad you did so in the long run.

Final Thoughts

When it comes right down to it, we have no control over what the government is going to do in an effort to jumpstart the economy. Increased taxes and spikes in inflation are both unpredictable, but distinct, possibilities.

Rather than worrying about what the elected officials in Washington may or may not do, why not just worry about what you can control? Namely, your own portfolio. The best two pieces of advice are: increase your retirement savings by as much as you can (save until it hurts!), and diversify.

What are your thoughts on the current state of the U.S. economy, and what do you think about investing for retirement going forward?

David Bakke is a PerkStreet Financial customer as well as a frequent contributor for the Money Crashers personal finance blog, where he shares his insights on shopping smart, building wealth, and saving for retirement. David lives in Atlanta, GA with his young son. You can find Money Crashers on Twitter (@MoneyCrashers) and Facebook.

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