Are you considering a new investment or evaluating investments that you already own? While there are some complex analysis tools, some of the best ways to evaluate an investment are based on simple and practical assessments.
The criteria for evaluating an investment include meeting acceptable risk, goals, valuation, time frame, objectives, cost, and other assessments explained below.
After buying thousands of investments over the past 40 years among stocks, bonds, funds, commodities, small business and real estate, I’ll share what I’ve learned on how to evaluate an investment.
Note that the focus of this article is on evaluating both traditional investments such as stocks and bonds, as well as more alternative investments since they can all work together to create a portfolio that meets your needs.
Risk When Evaluating an Investment
Keeping wealth is as important as creating wealth. Evaluating risk may be the very first step you want to take.
When you evaluate an investment, you’ll want to ask the following questions:
Does the investment have an acceptable level of risk for me?
How much does the investment typically go up or down each year?
And most importantly, what is the probability that all or most of my capital will be lost completely? For example, while an investment in the S&P 500 index will fluctuate in value, it’s extremely unlikely that all of your money will be lost unless there is some sort of extreme disaster.
But an investment in a startup, real estate, or oil drilling venture can be lost completely. If you are not in a place where you can afford this level of loss, this would immediately rule out such an investment early on in the evaluation process.
Evaluation for Fulfilling Your Wealth Plan
Don’t get lost in the numbers and evaluation factors here. Simply put, evaluating any investment is part of an overall wealth plan to reach financial independence.
The goal of evaluating any single investment, then, is identifying whether it will be the easiest way to do that. And all the potential investments you own or are evaluating will ideally fit together like the squares in a quilt to fulfill your overall wealth plan.
This plan is set but flexible as market valuations change introducing new opportunities or limiting opportunities. The remaining criteria for evaluating an investment outlined below will facilitate discerning if an investment will help you do that.
Evaluating an Investment with Current Vs Historical Pricing
When you buy assets that are below market value in comparison to other investments or by historical measures, you get more assets for your money. Plus, quality investments are more likely to increase in value, which builds wealth over time.
Since most investors own stocks, I’ll start with the importance of current vs historical stock valuations. But as an investor in both stocks and alternative investments, I will address into evaluating alternative investments also.
Evaluating an Investment in Stocks Using Valuation
Stocks can be evaluated as an entire market or as a single security as explained more below.
Using Investment Pricing When Evaluating an Investment
One of the most important things in evaluating an investment is to see how much the investment cost in comparison to history. This is because in general, investments move back toward the average of historical pricing.
For a single stock, you won’t compare $5 vs $50, for example. Instead, current prices are compared to historical prices based on how much they make in earnings.
This is done by checking the Price to Earnings Ratio, or PE ratio.
Similarly, you can also see how the overall stock market (vs a single stock) is priced in comparison to history.
While this may sound complex, it’s easy to measure the overall markets by looking at the PE of the S&P 500 index or other indexes, depending on the investment you are evaluating.
So, a starting point for evaluating a stock investment begins with seeing if the overall market is overvalued based on historical norms, and then narrowing down more if a single stock is the focus of the evaluation.
Checking Market Direction When Evaluating a Stock
In addition to pricing, the direction of a overall market is also super important when you evaluate an investment. This is because the price of an investment tends to move in the direction of the overall markets, which is tied to the pricing, which is tied to the economy, basically.
In other words, if you are evaluating an investment in Microsoft, you’re going to check and see how the S&P 500 is valued in relation to history.
Then if you like what you see, you can check how Microsoft’s PE ratio compares to it’s own historical PE ratio.
An investment that has a low valuation coupled with being in an up trending market has a higher probability for a capital gain (increase in value).
See the capital gain section below for more on this.
Does the Investment Fit My Goals?
When evaluating an investment, one of the first things to do is see if an investment is likely to deliver the desired result you are seeking based on your overall wealth plan.
You buy certain things, at certain times, for an expected and needed result. For example, you a buy wool coat for warmth in winter, and sandals so your feet stay cool and protection from abrasions in the summer.
Similarly, you buy investments because you want them to have a certain result. People often loose site of this.
There are 3 main results desired from any investment. They are:
- Capital Preservation
Again, defining the result is a forerunner for evaluating any investment so you can see if the investment will deliver the result you want.
Income investments are generally purchased when you want to live off investments. Believe it or not, too much income can actually be a bad thing since it can increase your taxes.
Having said that, I am drawn to income producing investments at my age and especially during high overall market valuations. This is because income investments (stocks and bonds) tend to drop a little less during bear markets than investments that don’t pay income.
Growth is the result you are seeking with the expectation an will increase in value. This is also called capital appreciation or capital gains in investing lingo.
By traditional investing rules, growth investments are sought when you are younger, working and saving money for that one magical far off day when you will live off investments. This strategy works well for a lot of people, especially people who are busy with work and don’t want to spend time on their investments.
The thinking goes later, when you retire and no longer have employment income, you invest in income producing assets.
As a rule, the older you get, the less time you have to accumulate wealth from passive long term growth, so the less money you tend to have in growth assets. An exception would be if you are very wealthy and are focused on leaving a legacy.
This is because you probably have plenty of income generated from your investments to cover your living expenses.
Capital Appreciation At Any Age and Any Asset
I like to bend traditional retirement planning rules to buy assets at low valuations and avoid buying assets at high valuations at any age.
Also, almost everyone thinks of stocks for growth investments, but growth can and does often come from other assets besides stocks. You can, for example, reasonably expect growth from the value of rental properties over long periods of time. This is especially true if they were bought at low valuations.
Bonds and commodities can also increase in value at certain times. If your goal is capital appreciation, when you evaluate an investment, you can look to history to see if it looks probable that an investment will increase in value based on pricing relative to historical pricing, as explained above.
Remember, capital appreciation can happen for any investor who buys undervalued assets which subsequently increase in value. It makes sense for any age investor to seek undervalued assets as part of your investment evaluation.
This is because growth occurs when the value of an investment returns to higher, more normal valuations.
Click here to read my post How Much Money Do You Need to Retire? with more information on capital appreciation and timing.
Capital Gains When Investing Later in Life
For investors nearing retirement without enough savings, a more proactive investment method can lead to “catching up”. In traditional retirement planning, individual investors are usually encouraged to invest money into stocks whenever they can with disregard to asset valuations for the most part.
This is because of the emotions that can enter into investing that lead to investing mistakes. And it is also because no one can predict the exact end of a major asset trend.
But when evaluating an investment, it’s more about how the valuation currently compare relative to average historical numbers.
Numbers and facts don’t lie, and they’re available for anyone willing to look at them. Evaluating historical data can lead you to fine tune the percent you put into an asset class at any given time to, at a minimum, lower risk and increase returns.
This is why an important part of the investment evaluation process is checking the probability that any investment will deliver the results you want based on current and historical valuations.
Click here to read my post How to Understand Your Investments with more information on income vs capital gains as examples.
Don’t Lose Money = Capital Preservation
Simply not losing money is called capital preservation in financial lingo.
When evaluating an investment, if your main goal is no loss in value, you’ll want to make sure there is zero expected change in the principle value, and that there is good insurance coverage in the event the financial institution defaults.
Usually when money is invested with the goal of no potential for loss whatsoever it is done for two reasons. First, it’s done to make sure a portion of your net worth is available in the event of job loss or unexpected emergency costs.
Or it can be done when you think assets are overvalued and there will be good opportunities in the near future that will require capital/cash to capitalize on. This is what all financial advisors and wealth managers do by keeping a portion of their client’s money in money markets or similar investments.
Some more proactive financial advisors will raise “cash” levels significantly when they think the market has gotten overvalued but this is not common.
I have noticed that many funds and wealth managers show capital preservation as a primary goal with money that is invested in the stock market. But we know that in reality all money invested in stocks will move down in value at times, and will also, hopefully, move up in value.
Again, in evaluating an investment, you’ll first define the outcome you want and then see if that investment has a high probability of delivering that outcome. The rest of this post will address more specifically how to evaluate an investment to see if it will likely accomplish this goal.
Evaluating an Investment for Return Time Frame
Once you have decided what result you want from an investment, you’ll want to see if the time frame works for you with regard to expected outcome.
Income Investments and Time Frame
Most income investments pay immediately or within a few weeks of purchase so this is easy to check. Many income investments pay quarterly, and many pay monthly dividends or interest.
Quarterly income can be a little tricky for retirees who need consistent monthly income, but it can certainly be made to work for investors living off investments. If consistent monthly income is important to you, you’ll want to see how often income is paid when evaluating an investment.
On the other hand, if you are investing in a startup that will not have profits for years, you won’t get paid income unless you have an agreement that specifies income during the startup phase (which does happen).
Similarly, if you are buying a house to fix up and rent, receiving income could be delayed for several months.
But with most traditional income investments into stocks and bonds, income is easy and immediate, which is a huge benefit of investing in them.
Evaluating an Investment to See If It Will Increase In Value Over Your Desired Time Frame
Return time frame gets a bit trickier with capital gain investments since most investments with this expected outcome fluctuate in value, and it’s hard to predict exactly when an investment will increase in value. The stock market is a perfect example, but this same principle applies to all assets that change in value.
For example, everyone knows that over long periods of time (5 to 20 years, depending on the time frame) the annual stock market return is around 10%, but each year returns can vary greatly from that often quoted 10% annual return figure.
In other words, while huge swings are not the norm, based on history the stock market can be up 25% in one year or down 25% in one year.
This makes it a challenge for stock investors to reliably evaluate the time frame for an investment to increase in value over shorter time frames.
Looking to the performance of an asset class, such as stocks or real estate, over the preceding few years can be a guide to the return you can expect in subsequent years.
Bulls Markets and Bear Markets
The good thing for stock investors is that stocks go up in more years and for longer time frames than they go down.
- Bull (rising) markets last 4.5 years on average. (1.)
- Bear (falling) markets last only 1.4 years on average. (2.)
If you’re evaluating an investment for an increase in value (capital gain) over a long time frame, you may choose to not worry about the next few years and focus on the long term.
On the other hand, if you’re evaluating an investment for doubling in value over the next ten years so you can retire, checking the returns of the preceding years would be time well spent and here’s why.
While it is counter intuitive, investments go down following years of bull markets and up following a bear market. You can use this easily accessed information to help you evaluate an investment for capital gain potential with increased probability within a given time frame.
Click here to read my post How to Know if the Stock Market Will Go Up or Down with more information on this.
Alternative Investments Vs Stocks and Bonds
In evaluating an investment, an early starting point is to clarify if you want to invest in alternative investments or in traditional investments, such as stocks and bonds. Interestingly, many people think of investments as stocks and bonds only.
This is like eating only meat and bread. Just think of the impact of adding a side of guacamole to meat and tortillas. You can get a completely different outcome, a better outcome.
Similarly, investors can add slightly alternative investments in assets like REITs or MLPs to alter investment results when appropriate with little effort. Likewise, adding real estate rentals, covered calls or small business to your investment portfolio can significantly change your investment results.
Before limiting your research to stocks and bonds, decide if this is the only area in which you want to invest. If not, get clear about how alternative you want to go with your investments based on your goals, time and resources.
Then when evaluating an investment for your specific portfolio, see where and how the investment fits into your decision of alternative vs traditional investing. Otherwise, most investors simply default to the comfort of stocks and bonds simply because they are thought of as investing staples that must be in every investment portfolio.
It’s easy to forget that everything is a decision, including your investment decisions. Click here to read my post How to Manage Wealth with more information on this.
Because of this, most investors only ever consider evaluating stock and bonds investments. Before you begin the process of even choosing investments to evaluate, decide if you want to allocate a portion of your net worth to alternative investments, and what percentage.
Then see if the investment you are evaluating fulfills that percentage.
Evaluate an Investment from a Cost Perspective
When evaluating an investment, an important factor is the cost to buy and own that investment.
The Cost to Purchase an Investment
The first factor is how much it will cost to purchase an investment in terms of fees and commissions. While most investors have gotten wise to not paying up front commissions for funds, I still see many funds with upfront costs.
There can also be redemption costs when you sell a fund, usually to dissuade investors from selling or moving in and out of asset classes based on valuations.
Fee Examples at Vanguard
For example, even low cost leader Vanguard has a 1% purchase fee for both its retail and institutional Long Term Corporate Bond Index Fund Admiral Shares (VLTCX and VLCIX).
Vanguard also has a .25% purchase fee and redemption fee on their International Dividend Appreciation Index Fund Admiral and Investor shares, VIAAX and VIAIX. (Admiral funds have higher minimums and usually slightly lower costs than Vanguard’s other funds.) (3.)
Other funds have purchase fees or redemption fees of 2% or more.
In evaluating an investment, you’ll want to know the cost to buy an investment.
Then you’ll want to see if you can buy and sell comparable investments for less money.
Evaluate an Investment from an Ownership Perspective
The second cost area relates to owning an investment. Funds have expenses that are incurred to operate the fund. These are expressed as an expense ratio.
An expense ratio of .20 charges .20% of the amount of your investment, for example.
It’s important to evaluate these fees ahead of time because you don’t actually see these expenses being deducted. They are taken out of the fund assets before you get your portion, making this an important part of your initial investment evaluation.
When evaluating an investment, such expenses are really important and here is why. You can easily invest in a S&P 500 index fund with an expense ratio of .10 or less these days.
Plus, there are a lot of funds that own a selection of stocks that end up performing about the same (or worse) than the S&P 500 index, but they have a much higher expense ratio, such as .85% or more.
A fund with higher fees has to beat the less expensive fund every year by the difference in fees just to break even with the more expensive fund.
With some financial coaching clients, I’ve seen the cost of investing in stocks get in the 1.50 to 2% range, annually, yet the returns are not better than lower cost alternatives. Returns are sometimes even worse than lower cost options.
Click here to read my post Pros and Cons of Working with a Financial Advisor with more information about this.
You can see how important the cost of owning an investment is when evaluating an investment. You’ll want to check the cost of owning any investment in stocks or bonds to a similar lower cost index or ETF.
The Cost of ETF’s
When evaluating any investment, I like to ask if I can get the same result from a similar method for less expense or effort. One of the cheapest ways to invest in stocks, for example, is with ETF’s.
ETF’s are Exchange Traded Funds that are bought and sold just like stocks. ETF operating expenses are often lower than mutual funds and other types of stock investments making the cost to own an stocks and bonds through an ETF very low.
The cost to purchase an ETF would be the normal commission you pay in your brokerage account.
Evaluating an Investment with Capital Cost
Most traditional investments (stocks and bonds) require 100% capital (unless there is some sort of margin account or leverage within a fund). If you are considering alternative investing, however, you’ll want to evaluate an investment from a capital cost perspective.
If you are only looking to evaluate traditional assets stocks or bonds, you can skip down to the next section. If you are considering alternative investments, this is an important factor in evaluating an investment.
Investments with Leverage
Real estate or small business investments often capitalize on leverage, since only a down payment can secure an entire property or business.
For example, if you invest $1 million in stocks with a higher than “normal” 5% dividend yield, your income is about $50,000 a year (before considering taxes and commissions.)
Referring back to evaluating an investment from a results perspective covered earlier in this post, remember that the change in the investment capital value could be up 25% or down 25% or more. Most years, however, have a less dramatic price movement.
This means that stocks and bonds require 100% capital which can increase or decrease in value shortly after the investment is made.
Leverage Investment Example
But what if you put that same $1 million in some sort of rental real estate? Depending on your credit and net worth, you could leverage your investment.
For example, if you put 33% down on each property, you could control $3 million of real estate. This means that your rental income could be three times as much as it would be with a single property.
You would, of course, need to factor in the cost of financing the properties, but this can obviously work better during periods of low interest rates.
Just like the stocks, the value of your properties could increase or decrease. This is why investors have to be very careful when evaluating an investment that involves financing (leverage).
The amount of capital required is one of the most important factors when you evaluate an investment. It provides a comparison tool among investment opportunities.
Financial Expert Rules
Some financial gurus, such as Dave Ramsey, are completely against leverage through financing. While financing increases the overall cost of any assets, sometimes it works for investors.
Then only hard and fast rule I have is that there are no hard and fast rules. I like to do what works given the current economy, outlook and individual situation.
For example financing real estate at 4% is entirely different than financing real estate when rates are 10%. When interest rates are low, perhaps there is an opportunity that doesn’t exist when interest rates are double that.
It can also make sense for an investor to have some investments that require 100% capital, such as stocks, and others that are leveraged, such as real estate rentals.
If using financing (leverage) allows in investor to acquire properties that have little or no cash flow so they are mostly or entirely paid for once the investor retires, this makes a lot of sense to me.
Everyone’s situation is different.
Analyzing an Investment for a Change in Net Worth
While they may seem surreal, remember that those increases and decreases in capital that your investments experience are increases and decreases in your net worth.
This is why when you analyze an investment, you’ll want to be realistic about the potential for a decline in your net worth.
The fact that the value of almost all investments increase and decrease in value takes us right back to the valuation. When you buy assets at lower than normal (historical average) valuations, your net worth is more likely to increase while you own them.
This results in wealth building, and it happens from evaluating an investment from a valuation perspective before buying it, and then following through with your evaluation findings.
Remember, wealth building happens on the purchase side.
In other words, when you buy quality assets for a low valuation, you’re much more likely to have a subsequent capital gain.
Plus, your risk of loss is lower. I don’t know about you, but lower risk makes me happy.
I do want to point out that some low cost investments are cheap for a reason. Any investment needs to be researched for other factors and to make sure profits are likely to continue.
Again, I have no hard and fast rules. But in general, buying undervalued assets gives an investor a good opportunity for building wealth through increased asset values.
Using Benchmarks for Evaluating an Investment
When evaluating an investment, a benchmark is an important tool that every investor will want to use when available.
This is easy for all traditional investments. You simply compare the past return performance to the performance of the index that most closely resembles the investments. For U.S. stocks, this is usually the S&P 500 index.
As for estimating future returns within shorter time frames, you can look at each year individually to see how much an investment swung up and down in a single year in the past to get an idea of how volatile an investment is.
This information is readily available for free online and it is a highly valuable and widely used evaluation tool.
Benchmarks for Oil and Real Estate Investments
REITs and MLPs have their own benchmarks. The oil ETF XLE is an excellent benchmark for oil companies, for example.
Benchmark comparisons can be more difficult with residential real estate, but I find the numbers for our real estate rentals much clearer and more under my control. For an initial evaluation, I start with my Look More rule.
My Look More rule is simply that if income from a rental property is around 10% of the cost of the property, I’ll look more.
If there are a lot of Look Mores, the overall market is undervalued. If Look Mores are rare, the market is overvalued.
Plus, I can compare everything back to a no risk money market return, and the return of the S&P 500 index. This sedge ways right into the next factor to evaluate an investment.
Opportunity Costs in Evaluating Investments
When you put your money into one investment you are giving up on an opportunity elsewhere.
For example, when everything is overvalued, the opportunity just may exist in higher levels of money market funds. This is because the capital will be there for future investments when valuations are low again.
Since money market returns are low and from interest only, this can feel like a waste of your investment capital.
And being in a money market during a bull market has a big opportunity cost since money in a money market is getting a fraction the returns during most years of a stock bull market. One big factor, however, is peace of mind from lower risk, especially during periods of high valuations.
Not only this, but it’s nice to have capital to invest when everything is undervalued again after a bear market, allowing an excellent opportunity later. It’s terrible when good quality investments are selling at half the price they were a year prior and all your cash is already tied up in fallen markets.
When evaluating an investment, realize that there is an opportunity cost for every investment, and make sure the investment you select is most likely to present the best opportunity.
Click here to read my post What Percentage of Cash Should Be in My Portfolio with more information on this.
Net Worth Diversification as an Investment Evaluation Factor
How well an investment fits into your current investment portfolio is an important factor when evaluating an investment. While I don’t use a static asset allocation, I think diversification is very important from both an income and a capital investment perspective.
You’ll want the amount of risk that any investment has to complement your other investments to equal the amount of risk you want to take. (Remember that the level of risk you take is a choice.)
Unlike most traditional wealth planning, I like to view net worth as a whole, including home equity, when evaluating any investment.
This is because the value of your home equity is subject to both increases and decreases depending on residential real estate valuations in your area. Plus, when stock markets drop, residential home values usually drop, too, creating a double hit to your net worth.
For this reason, I don’t think the amount of your net worth allocated to your home equity can be ignored when evaluating investments. For most investors, home equity or related financing is a big part of their net worth.
Click here to read my post Ways to Reduce Investment Risk with more information on diversification.
Summary for Investment Evaluation
As you can see, to evaluate an investment thoroughly, you’ll want to consider many factors. A good place to start is making sure an investment aligns with your overall wealth plan and acceptable risk.
Evaluating an investment well can help build wealth in addition to lowering risk.
I’d love to hear which of the evaluation factors above you’d like for me to write more about.
Disclaimer – This post is not meant to be construed as personal financial advice.