Five simple steps for comparing investments

One of the most challenging parts of signing up for a 401(k) plan or opening a Roth IRA is deciding which investment to put your money into. There can be dozens of options within your 401(k) plan and many, many more within a Roth IRA.

Of course, there are lots of possible questions to ask about an investment, and countless investment guides will give you lots of things to look at and think about. The problem is that they often give you too much to think about, leading to analysis paralysis.

How do you weed through all of these choices and figure out which investments you should be using? Here are five simple questions I use to figure out what investments I should be putting my money into. I try to answer each of these questions before I examine an investment. 

What is my goal?
This is the absolute first question you should ask yourself before looking at any investment of any kind. If you don’t have a goal in mind, investing is much like tossing darts in the general direction of a dartboard while blindfolded. You might get lucky and hit something, but you’re more likely to find that you’ve completely missed the target.

Why are you putting this money away? When do you expect to utilize that money?

Let’s say we’re looking at retirement, which is the goal many people have when they’re retiring. The goal of retirement comes hand in hand with a target date – usually somewhere around 65 to 70 years of age. The number of years until then depends, of course, on how old you are.

On the other hand, let’s say we’re investing because we want to open a little restaurant on Main Street. Your goal is to have enough money saved in five years to give it a real go.

Why is a goal important? Having a goal establishes your timeframe, which is a vital part of figuring out how to invest. Generally, you should only compare investments that you’re considering to support the same goal.

How volatile is this investment?
This leads right into the first specific question you should ask about an investment: how volatile is it? How rapidly does it go up and down? Generally, the closer you are to your goal, the less volatility you should accept in your investments because you can’t afford a big drop right before you arrive at your goal.

How do you check this? When I’m looking at investments, I find out what the annual rate of return has been for the past ten years for that investment. I then take the highest number and the lowest number and use them as a basis for comparison.

Generally, I’m willing to accept a 4% difference in those numbers for each year between now and the absolute final date for my goal. So, for example, if I look at an investment and the high number is 20% and the low number is -30%, that’s a difference of 50 between the numbers. I’m willing to accept that much volatility if I’m more than 12 years out for my goal. Otherwise, I move on to something less volatile.

This is a very simple way to check for volatility – there are many more sophisticated methods out there. However, this method does a pretty good job for its simplicity and it’s easy enough for almost anyone to understand it.

What I’ve found is that it allows me to invest in bonds more than 1-2 years out from my goal and opens the door to stocks starting at the eight or nine year mark.

What if you’re considering multiple investments? If you’re dividing the investments into equal pieces, then it’s pretty easy. You can “go over” your target on some pieces of the investment as long as you “go under” on other pieces.

So, if you’ve got a 10 year timeline and you want to put half of your money into something aggressive and half of it into something safe, then you just want to make sure that the total difference on both investments is 80 – an average of a 40 difference between the high and the low for each investment.

What are the fees on this investment?
This is the very next question you should ask.

All investment companies make money by charging some kind of fee on their investment. Usually, it’s an annual fee, expressed as a percentage of the value of your account. If you’re in an investment that has a 1% annual fee, what will happen is that over the course of a year, the company holding your investment will claim 1% of that investment for themselves.

Obviously, you’re going to want lower fees. I consider this the number one sticking point when comparing investments of similar volatility, since you simply don’t know how the investment will really perform in the future. What you do know is how much they’ll be taking from you – and you want that to be low.

Generally, investments described as “index funds” have pretty low fees, as they don’t cost much for the company to manage. I consider them to be pretty good deals.

What is the long term history of this investment?
The next question you should ask is what the long term history of these investments are. The big thing you’ll want to find out is how much, on average, these investments return each year.

Once you figure out investments that are acceptably volatile for you, you’re going to need to compare them carefully, and knowing how well they return is key.

I usually look at the average of the annual growth over the last ten years. This is usually found right in the basic information about an investment. I don’t really think too much about shorter terms than ten years.

It is important to note that past results do not guarantee future returns, which is why this is not the be-all end-all of tools to measure investments by. It just gives you a sense of how they’ve done in the past.

How diverse is this investment?
A final question to ask yourself is how diverse this investment is.

Is it an investment in a single item, like the stock of one company? That’s not very diverse – you should own a lot of different investments.

On the other hand, you might be looking at a fund that’s made up of the stocks of lots of companies. That’s much more diverse.

Not only do you want to own a wide variety of investment types – stocks, bonds, and so on – you also want a lot of variety within those types. You don’t just want to own one company’s stock, because if that company runs aground, you’ll be wiped out.

Generally, after looking at these questions, I have a good idea of what I should be investing in. For my retirement investments, for example, I found myself in “target retirement” index funds at Vanguard, which had acceptable volatility, a ton of diversity, solid annual growth, and really low fees. It did well in terms of all of the questions I was asking, so it’s what I chose to invest in.

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