How To Evaluate Investments

Whenever I talk shop with another investor, I’m often asked how I determine if an investment is a good one. While the answer is very subjective and personal, I evaluate 5 specific things every time I decide to pour money into a new investment. Today, I share what those are with some basic examples.

Opportunity Cost

Opportunity cost?Opportunity CostThe potential return or benefit you give up by choosing one financial option over another, like the future compound investment returns lost when spending money today. is an economics term that simply asks the question, “What could you make instead?” If you have idle cash sitting in a checking or savings account, for example, your bank is probably paying you a few pennies a year for parking your money with them. Is that a good investment? Absolutely not. So parking unnecessary cash in an account earning you close to nothing has a high opportunity cost, at least in monetary terms.

Opportunity cost, however, is subjective and relative to each person. So even though my example had a high opportunity cost from an investment perspective, it could have a different opportunity cost for your mental well-being. For example, if having a low cash balance prevented you from sleeping every night, the opportunity cost for keeping a high cash balance (despite being a poor investment) would mean your mental opportunity cost is low. This is why opportunity cost is very personal and depends on your personality and priorities.

This is all to say that whenever you are evaluating an investment, you need to think about what you could earn elsewhere, what owning this investment will mean for your day-to-day well-being (e.g., will you be anxious every day you own it?), and how much of your valuable time you will be spending on it.

Minimum Returns

Whenever I am looking into a new investment, one of the first things I do is determine its projected returns. That way, I can compare its returns to the historical average of stock market returns, which is 7-8% annually. If the potential investment’s returns aren’t at least as good as that, it’s a strong signal that the investment isn’t worth my time or money.

However, there are times when I may consider a lower ROI (return on investment) in exchange for diversification, stability, and higher cash flow. An example investment that typically fits this category is a rental property, which historically produces lower returns but much higher cash flow than stocks. The closer I get closer to reaching my $10M goal, the more open I am to sacrificing higher returns for higher cash flow because I will likely be reducing my risk, stabilizing my net worth, and becoming more dependent on cash-flowing investments as both my partner and I consider full-on retirement.

Timeline Matters

How long will you hold onto this investment? An investment isn’t much of an investment if you don’t plan to hold it longer than a year. Even the IRS penalizes you for doing this (in the form of higher tax rates) to encourage investors to hold investments for longer periods.

Keep in mind that some investments may lose money in the short-term, with the hope that long-term returns will outweigh the short-term losses. For example, real estate may be negative for the first year or two with initial, one-time setup costs, especially if you plan on furnishing the property. Or if you purchase a property without tenants, you will be guaranteed some losses until some (or all) of your vacancies are filled. Be sure your cash position is on solid ground before taking on an investment that’s guaranteed to produce some initial losses..

Risk vs. Reward

If an investment is deemed risky, I expect higher returns. Conversely, I expect a low-risk investment to yield low returns. If someone tells me that an investment is low risk with high returns, that raises red flags for me. Why would a low-risk investment yield high returns? That sounds like false advertising to me. Similarly, if I see a high-risk, low-return investment, that is an obvious no. I’d rather pick a low-risk investment to get the same low returns!

Tax Implications

Before buying an investment, you should have a general understanding of how it will be taxed. Here’s a simple checklist:

• What are the short-term gains tax rates?

• What are the long-term gains tax rates?

• Will I have any special tax deductions for owning this investment? Real estate typically has many, whereas stocks do not.

• Will the investment pay me any dividends? If so, will they be qualified or non-qualified dividends?Qualified DividendsDividends paid by regular US corporations and qualifying foreign firms that are taxed at lower long-term capital gains rates (0%, 15%, or 20%) instead of higher ordinary income tax rates.? Qualified dividends have preferred tax rates compared to non-qualified ones.

Conclusion

Always do your due diligence on your investment before putting your hard-earned money in it. That means running your numbers, conservatively, of course. It also means knowing how your investment will be taxed, how much time you will have to spend on it, and whether you will lose any sleep due to its risk level. Of course, every investor prefers different things, so comment below and let me know how you evaluate your investments!

To check what your funds really hold, try the ETF Overlap Screener, or compare options in our low-cost funds and ETFs guide.