Investing can be an intimidating topic for many people. It’s a world filled with unfamiliar terms and an almost limitless supply of options. We’re bombarded regularly with conflicting advice about the best strategies, the best investments, and the next “cant miss” opportunity. It can be difficult to tune out all the noise and focus on what truly matters.
Even when we already have an investment plan set up and running, we’re often presented with new investment opportunities that can seem pretty enticing. So how do we evaluate whether these new opportunities are right for us? We have to look beyond the hype and focus only on the aspects of the investment opportunity that are important to our specific situation. So today I’d like to talk about the five questions I think we all need to ask before deciding to put our money in any particular investment.
1. How does it fit with my overall investment plan?
This is really the overarching question that all of the questions below help to answer. Before putting your money into any single investment, you should have an investment plan that at the very least specifies a few key things:
- What are your goals? What specific things are you investing for?
- What is your investment time frame?
- How much and how often will you be contributing money?
- What risk are you willing to take on in the quest for returns?
- What is your overall plan for asset allocation?
No investment decision should be viewed in isolation. You aren’t just buying a stock, or a bond, or a mutual fund, or whatever. You’re buying an additional piece of your overall investment portfolio. An investment that looks good on its own may not be a good decision for you because it doesn’t fit well with your other investments. The opposite could also be true, where an unappealing investment for one person could be perfect for another.
To give you an example from my own personal investment plan, I choose to keep the bond portion of my investments in US government-issued Treasury bonds as opposed to bonds issued by companies that would give me a higher interest rate. I willingly choose a lower-returning investment because it fits better with my overarching goal of using stocks to provide my long-term returns and bonds to protect me during the periods when stocks falter. Treasury bonds serve my specific purpose better than other bonds, so they’re the better choice for me when considered within the context of my overall investment plan.
2. Do I understand it?
If you can’t understand how something works, you shouldn’t invest in it. There are several reasons for this, chief among them that if you don’t know how a particular investment works, you can’t properly evaluate your answer to Question #1. How can you understand whether it helps you reach your goals if you don’t even know how it’s supposed to work?
Bad products are often sold to consumers on the faulty logic that sophisticated investing has to be complicated and therefore above the comprehension of the average person. I once had a life insurance salesman explain the benefits of whole life insurance as an investment by showing me his watch that he had apparently just bought and saying he didn’t know how it worked, he just knew that it worked. Wow! Sounds great! Sign me up!
Look, the best investment strategies are simple. They’re not the best because they’re simple, they’re just objectively the best and it’s a nice benefit that they’re also simple. If you’re new to investing you will have to do a little bit of learning to understand your various options and how they work. But there’s nothing worth investing in that you can’t come to understand.
3. What is the investment’s track record?
It’s important to understand the history of a particular investment so you can have some idea how it will behave in different environments. How will it act during economic booms? How will it act during a recession? How will it be affected by inflation? All of these questions help you get closer to your answer to Question #1. Ideally, you’d like your investment portfolio to have a few different investments that behave differently in different conditions. That way no matter what’s going on in the world, at least part of your portfolio will be performing well.
There are some big warnings that come with this question. The first is the generic advice that past performance is no guarantee of future results. There is no crystal ball here. We cannot predict the future. The best we can do is identify consistent trends from the past and apply them prudently in our plans going forward.
It’s also important to recognize that the more specific you get, the less reliable past performance is. As an example, you can get a decent sense of how the stock market as a whole should behave in different kinds of economic conditions, but things get much murkier when looking at any specific stock.
Finally, be very aware of how much history the investment has. A 10-year track record is actually not very much time at all. Even the stock market, for which we have data for over 100 years, still shows us behavior we’ve never seen before. That doesn’t mean you should automatically avoid anything new, but it does mean you should be extremely cautious and know that you are taking on extra risk when investing in something without a long history.
4. What are the costs?
Studies show that cost is actually the single best predictor of future investment performance. Morningstar even found that cost predicted the future performance of mutual funds better than their own widely-used star rating system.
With that in mind, you should be acutely aware of the various costs associated with whatever investment you’re considering. Mutual funds have one potential set of fees, but other types of investments will differ. These fees should be very transparent, and if they’re not you should be wary of both what is being offered and who it is offering it to you. Remember that returns are never guaranteed, but fees usually are.
5. How easily can I get out of it?
Successful long-term investors are people who craft a well thought out plan and stay consistent with it through the ups and downs of the market. They are not people who try to move in and out of different parts of the market based on current conditions or predictions about the future. That kind of constant activity is a recipe for failure.
With that said, not every decision you make will be a good one and you need to know what your options will be for changing your mind if you decide it makes sense to do so. You should be able to get out of any investment quickly and with little cost. As an example, a good mutual fund will allow you to sell out of it by the end of any given day and will cost you nothing more than the cost of a typical trade (if that) to do so. You may have lost money on the investment, but there’s no extra cost for deciding to get out.
On the opposite end of the spectrum, one of the reasons I consider whole life insurance to be a bad investment is that it’s typically very costly to cancel the policy. Certain mutual funds are also costly to sell, as they charge something called a redemption fee, which is essentially a percent of your investment that goes to the investment company if you decide to sell. With other types of investments, you may not even have the option of getting your money back before a certain amount of time has passed. All of these things that make it more difficult to get out of the investment should make you think a little bit harder before getting in.