Updated Nov 5, 2021
Are you considering a new investment or evaluating investments that you already own? The foundation for evaluating an investment begins with simple and practical assessments that relate to your personal financial goals.
To evaluate an investment, the following criteria should be met in alignment with a defined overall investment plan: acceptable risk and return levels, value relative to history, time frame, overall objectives, cost, and capital allocation requirements.
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 about how to evaluate an investment. While I’m an AFC® (Accredited Financial Counselor), the information in this post comes from my own experiences.
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.
♦♦ In a hurry or TMI? Scroll down to the table I created summarizing all the factors to evaluate an investment and how each factor can help you reach your life and financial goals. ♦♦
Risk When Evaluating an Investment
Evaluating risk is the very first step you want to take when evaluating an investment since keeping wealth is as important as creating wealth. If one investment is too risky, you can quickly move to the next investment you’re considering since there are many investment options.
When you evaluate an investment, you’ll want to ask the following questions regarding risk:
Is the level of investment risk acceptable 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 investments in stocks go up and down, it’s extremely unlikely that all of your money will be lost for good quality companies or an index fund.
On the other hand, an investment in a startup, real estate deal, or similar alternative investment is completely lost much more often. The potential reward is higher, but so is the risk. If you are not in a place where you can afford this level of loss, too much risk would immediately rule out such an investment early on in the evaluation process.
It can be very hard to evaluate risk when selecting investments or even investment strategies. Fortunately, tools such as Allocate Smartly are making it easier to evaluate risk by providing with the past performance results for up to 50 years for the strategies for which they provde data.
Evaluation for Fulfilling Your Investment Plan
Don’t get lost in the numbers and evaluation factors here. Simply put, evaluating any investment is part of a larger, personal wealth plan to reach financial independence.
The goal of evaluating any single investment, then, is identifying whether that investment provides the easiest way to reach your financial goals. In the end, all the potential investments you own or are evaluating will ideally fit together like the pieces of a puzzle to fulfill your overall financial goals.
Such an investment plan should be set but flexible as life changes, and as market valuations change introducing new opportunities. The remaining criteria for evaluating an investment outlined below will facilitate discerning whether an investment will help you reach the goals outlined in your own wealth plan.
Evaluating an Investment with Current Vs Historical Pricing
One of the most important factors in evaluating an investment is whether that investment offers good value at the time of evaluation.
When you buy assets that are below value in comparison to other investments or by historical measures, you get more assets for your money.
Plus, undervalued quality investments are more likely to increase in value over time, which helps build wealth.
Since most investors own stocks, I’ll start with the importance of current vs historical stock valuations.
As an investor in both stocks and alternative investments, I will address evaluating alternative investments also.
Valuation When Evaluating an Investment in Stocks
Stocks can be evaluated as an entire market or as a single security as explained more below.
Pricing When Evaluating an Investment
One of the most important things in evaluating an investment is to see how much the investment costs in comparison to history. This is because in general, the stock market moves back toward the mean (average) of historical pricing, and most stocks move with the overall market.
In order to get back to the mean, the stock market has to drop far below the mean price. This is what the stock market has done historically, so it is safe to assume this pattern will continue.
Seeing how an investment is priced relative to history provides valuable insights when evaluating an investment for potential future price movement.
For a single stock, you won’t compare a $5 price vs a $50 price, for example; this tells us very little. Instead, current prices are compared to historical prices based on how much an investment cost relative to its earnings.
This is done by checking the Price to Earnings Ratio, or PE ratio. Many investors use the more current CAPE, or cyclically adjusted 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 ratio of a single stock or the S&P 500 index or other indexes, depending on the investment you are evaluating.
A good 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.
Does the Investment Fit My Goals?
Many investors think in terms of whether an investment is good or bad. The reality is that what might be a good investment for one investor is a bad investment for another investor.
Part of the evaluation process for any investment, then, needs to be whether the investment is likely to deliver the desired results based on your personal overall wealth plan.
You use your money for 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 in the summer.
Similarly, you buy investments because you want them to have a certain result.
There are 3 main results desired from any investment which are foundational in the evaluation process. They are:
- Capital Preservation
Again, defining the result you are seeking is a forerunner for evaluating any investment so you can easily see if the investment will deliver the result you want. Let’s look at each of these investment goals, or results, in more detail.
Income investments are generally purchased when investors want to live off investments or retire. Income investments pay you while you own them.
While it may seem that income would always be a desired investment outcome, there are pros and cons of income investing:
- Increase income taxes
- Lessen capital gains potential
Many older investors seek income producing assets in preparing for retirement. Assessing income from a yield and consistency perspective, then, becomes an important part of the investment evaluation process for income investors.
Growth comes from an increase in price over the purchase price.
Growth results in building wealth.
Growth is also called capital appreciation or capital gains in investing lingo.
By traditional investing rules, younger investors who have plenty of time before the time they wish to live off investments should have a higher allocation in growth investments.
Later in life, after employment income has ceased, most growth oriented investors transition to income generating investments.
As a general rule, the older you get, the less time you have to build wealth from growth investments. The amount of capital gains potential an investment has, then, is an important factor in the evaluation process for growth oriented investors.
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 capital preservation, you’ll want to make sure there is zero expected change in the price. Money market funds or short term bonds (bills or notes) are the most common investments for capital preservation.
Having the ideal percentage of portfolio cash is a priority for evaluating investments with a focus in capital preservation. Cost and yield are other important factors, especially given the low interest rates of recent years.
Again, in evaluating an investment, you’ll first define the result you want and then see if that investment has a high probability of delivering that outcome. Next, let’s focus on 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 the result you want from an investment, you’ll want to see if the time frame works for you with regard to the expected outcome.
The desired time frame for income investments will be evaluated very differently from the desired time frame for growth investments so let’s look at each of these next.
Income Investments and Time Frame
Most income investments pay income immediately or within a few weeks of purchase depending on the payment schedule. Some income investments, such as stock dividends, pay quarterly, while some pay monthly dividends or interest.
If consistent monthly income is important to you, you’ll want to see how often income is paid when evaluating an investment. 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.
The income and time frame criteria are different for alternative investments.
For example, 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. Mr. Wonderful from Shark Tank is a good example of this with his royalty payments.
Similarly, if you are a real estate investor buying a house to fix up and rent, receiving income could be delayed for months.
With most traditional income investments into stocks and bonds, income is easy and immediate, however. This is a huge benefit of investing in traditional assets.
Evaluating an Investment for Growth Time Frame
It’s much easier to evaluate investments for income vs capital gains since income tends to be more predictable and reliable than capital gains from both an amount and timing perspective.
Investors can calculate investment income based on yield while gains potential is a future unknown estimated during the evaluation process.
First, growth type investments tend to fluctuate in value more than income investments making the timing unpredictable.
Additionally, it can take years for an investment to increase in value by the desired amount while investment income is often paid within a few days or weeks.
High growth stocks are more likely to increase in price short term than more established, dividend paying stocks, however.
Yet stock market cycles also come into play here. Therefore, making an investment near the beginning of a long term cycle can certainly expedite the time frame required to reach desired capital gains.
For example, everyone knows that over long periods of time (10 years or longer, depending on the time frame) the annual stock market return is around 10%, but each year returns can vary greatly from that often published 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 during which an investment will reach goals for growth. This is true for both stocks and real estate investments.
Looking to the performance of the asset class, such as stocks or real estate, over the preceding few years, however, can be an aid in predicting the return you can expect in subsequent years.
Again, this makes overall market valuation and direction important when evaluating an investment.
Evaluate an Investment from a Cost Perspective
When evaluating an investment, an important factor is the cost to buy and own that investment. There are two major cost areas.
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. Most investors have gotten wise to upfront commissions when buying funds, but there are still 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.
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).
Other funds have purchase fees or redemption fees of 2% or more.
In evaluating an investment, you’ll want to assess if you can buy a comparable investment for less cost.
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 every year, 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, making this an important part of your initial investment evaluation.
When evaluating an investment, such expenses are really important, and here’s why. You can easily invest in an S&P 500 index fund with an expense ratio of .10 or less these days.
Many funds that own a selection of stocks 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 yet the return and risk are similar if not the same.
With some financial coaching clients, I’ve seen the cost of investing in stocks in the 1.50 to 2% range, annually, yet the returns are not better than lower cost comparable alternatives.
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 similar lower cost index funds or ETFs.
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).
The question to ask when evaluating an investment from a capital cost perspective is how much capital is required for the result you want.
For example, let’s say the result you desire is income, as previously addressed, and the investment being evaluated is a dividend stock fund that yields 3%. The result you’ll get from investing $100,000 capital is $3,000 income a year.
On the other hand, if your desired result is growth of 6% a year on an investment of $100,000, the result will be $6,000 IF the investment increases as planned.
Please note that this is a very large “IF” since capital gains are unpredictable as addressed elsewhere in this post. We’ll go with this assumption, though, to illustrate the capital cost factor in evaluating an investment.
What about an income generating asset that yields 5% a year and has a good capital gain potential of 5% a year? In this case, a $100,000 investment that performs as expected will provide $5,000 investment income and $5,000 capital gain.
In all three cases, investment capital of $100,000 was used to get different results.
If you are only looking to evaluate traditional assets such as stocks or bonds, you can skip down to the next section. If you are considering alternative investments, capital is an important factor in evaluating an investment.
Evaluating Alternative Investments and Capital
Alternative investments warrant more complex evaluation from a capital cost perspective since they frequently involve leverage.
Investments with Leverage
Real estate or small business investments often require only a percentage down payment to secure an entire property or business, contrary to most stock investments.
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.
Leverage Investment Example
What if you put that same $1 million in some sort of rental real estate property? Depending on your credit worthiness, 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, which will obviously be much lower 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 especially diligent 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.
How to Evaluate an Investment
|Check These Evaluation Factors||Why?|
|Investment Aligns with Personal Wealth Plan||Ultimately Achieves Life and Financial Goals|
|Current Vs Historical Asset Pricing||Manages Risk and Reveals Opportunities|
|Income Vs Capital Gain Potential||Results in Needed Investment Objective|
|Meets Desired Time Frame||Delivers Investment Results When Needed|
|Cost to Buy and Own Investment||Investor Keeps More of Investment Return|
|Investment Capital Required Relative to Results||Best Capital Use Among Various Investments|
|Stock Bond Portfolio Vs Alternative Investments||Increased Opportunities and Diversification|
|Comparing Returns with Indexes||Provides Excellent Free Evaluation Tool|
|Opportunity Cost of Any Investment||Improves Ability to Spot Better Investments|
|Evaluating from Total Net Worth||Provides Better Overall Evaluation|
Using Benchmarks for Evaluating an Investment
When evaluating an investment, a benchmark is a very valuable tool that every investor will want to use when feasible.
This is easy for all traditional investments; investors can simply check the past performance of any investment to that of the closest benchmark. For U.S. stocks, this is often the S&P 500 index.
Benchmark information is readily available for free online and it is a highly valuable and widely used evaluation tool.
Today many investments are the benchmarks themselves. In other words, investors buy a stock or a bond index fund. In this case, when evaluating index based investments, investors can compare similar indexes, such as an S&P 500 index vs an all stock index, and index funds vs ETFs.
All the other criteria in this post will also apply, such as costs, time frame, and desired investment results when evaluating an investment.
Benchmarks Real Estate Investments
Benchmark comparisons can be more difficult when evaluating real estate rental properties unless they are purchased as a REIT or other fund.
For an initial investment evaluation, I start with my Look More rule.
My Look More rule is simply that if income from a rental property is near 5% to 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.
Opportunity Costs in Evaluating Investments
When you put your money into one investment you are giving up on an opportunity elsewhere.
When evaluating investments, a no risk money market return or the return of the S&P 500 index is often used for comparison.
Investors must consider investment valuations and fluctuations when comparing investments, however.
For example, when everything is overvalued, the best investment could be holding a higher percentage of portfolio cash in 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 approach can come at a cost, however.
This is why investing from an overall wealth plan that clearly defines desired return and acceptable risk is important.
Net Worth 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 fixed (buy and hold forever) asset allocation myself, I think diversification is very important for all investors from both an income and a capital investment perspective.
You’ll want the amount of risk that any investment has to complement your other assets to equal the amount of risk you want to take.
For this reason, 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 stocks go down, residential home values often drop, too, creating a double hit to your net worth.
On the other hand, home values generally increase during periods of favorable economic times and bull markets.
For this reason, I don’t think the amount of your net worth allocated to your home equity can be ignored when evaluating investments since home equity and related financing are a big part of their net worth.
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.