Think about more than timing: 6 questions you should ask yourself before making any investment

While there are many issues to consider when investing, most people make a decision based on a single question: “Is it a good time to buy?”

I can sympathize because I used to think that way. My first investment was a speculation on an airline stock since I had a hot tip that low gas prices would boost earnings (this didn’t turn out so well). I was in high school then and sought my broker’s advice about what went wrong.

He explained my critical mistake was focusing too much on market timing. He told me that investing, whether in stocks or otherwise, is not about timing but rather about buying a quality product. I would later learn about the folly of market timing in my economics classes at Stanford, but at the time I wanted something more practical. If timing wasn’t the most important criteria, then what was?

My broker explained there are many issues. He pulled out a sheet of six questions he asked his clients. I took the list and I was amazed at how much better of an investor I became over the years by thinking about such issues.

While this list is by no means comprehensive, it was a good starting point for me and I’d like to share it. Here are the six questions to ask before making an investment:

1. How does the investment help you reach your specific investment and financial objectives?

Everyone knows that investing for retirement is different than saving for a new car. The main difference, of course, is that the money is set aside for different purposes.

Where you invest ultimately depends on why you want the money. This is why financial advisers rarely talk about investments on the first visit, but rather about your goals and your current situation. It’s important to keep a holistic perspective. Ultimately, it is knowing and satisfying your goals that can help you acquire meaningful wealth (as I’ve written about wealth before).

2. How safe is the investment?

Economists often remind us there is no such thing as a risk-free investment. Even checking accounts have a (low) chance of defaulting. Safety is therefore usually a comparative exercise and it is as much as art as a science.

While there are no hard and fast rules here, if you’re investing in debt, then at a minimum check the ratings of lenders and bonds at a credit rating agency (like Moody or S&P). With stocks you can look into volatility.

3. How quickly can you cash out the investment (how liquid is it)?

This question can help you make some of the tougher decisions. It is your time preference that dictates whether you can hold out during down markets. A lot of “really great” investment options like houses and retirement accounts often come with the downside of less access to cash. There is no secret to getting the right mix other than experimenting with several investment options (many of us need more cash for emergencies than we think).

4. What is the expected return on the investment?

This question is easier to answer for CDs and savings accounts where rates are stated. But it is not always that simple since rates can change. Retirees have to worry about the risk when their CDs get rolled over at a lower interest rate (called reinvestment risk). With stocks or mutual funds it is useful to look at historical returns in comparison to similar asset classes. But as they say, past performance is not indicative of future results.

5. What does it cost you to buy, own, and/or sell the investment?

Fees can eat up the profits of a good investment. Here’s a nice article on fees and why you should strive to lower them from financial writer Scott Burns:

Yes. The longer you invest, the smaller the performance difference between entry into the top 25 percent of performers and entry into the bottom 25 percent of performers. The difference is so small that over 15 years it may amount to less than you pay in fees.

In other words, what you pay in management fees can wreck your investment performance, all by itself. This is why I often refer to professional money management as an iatrogenic illness— a treatment that is worse than the malady it purports to cure.

[source: Fees and the Top and Bottom 25 Percent]

6. How is the investment income taxed?

Taxes are an useful but secondary consideration. Here’s an explanation I gave in an earlier article about investment taxes:

Taxes are an important component of many decisions, but don’t let it get in the way of focusing on the take home return. It is financially better to get a 10% return and pay 20% in taxes for a net 8% return than to simply get a 7% tax-free return.

The decision obviously depends on your marginal tax bracket. Let’s compare a tax-free 3% municipal bond to a taxable 4% CD. In the lowest tax-bracket, the investor is choosing between an after-tax return of 3% on the bond and 3.6% on the CD–so the CD is better. In the highest income bracket, the investor is choosing between an after-tax return of 3% on the bond versus a 2.34% on the CD–making the bond better. This is an example of how the rich can benefit from tax-advantaged investments more than lower tax brackets.

[source: Understanding how taxes affect your finances]

What questions do you ask?

This list is truly a starter, so what can you add? While I don’t always go through such lists any more, they are often useful as a reference when I’m evaluating a new product and I want to make sure I get all the facts. Do share if you ask yourself questions about risk, expected return, company history, etc. that could help others ask more questions besides “is this a good time to buy?”