For most people, one of the most intimidating parts of signing up for a 401(k) or a Roth IRA or another investment account is looking at all of the investment options. How do I know which one is right for me? How do I compare them?
I remember exactly how that feels. When I signed up for the retirement plan at my very first job after college, I was hit with a plethora of investment options. I had no idea what to pick, nor any idea of how to really compare them. It was intimidating and because of that intimidation I just chose the option that our retirement advisor suggested.
Luckily, the option he suggested was one of the best ones, but I didn’t realize that at first. Instead, I worried about it. Did I choose the right thing? Should I be invested in something else?
So, I started to do some homework. I actually read through several prospectuses (for those unfamiliar, those are the fairly long booklets that describe in excruciating detail all of the specifics of a particular plan). More importantly, I checked out some books on investing from the library and devoured them cover to cover.
The key thing that I learned? Investing can be an endless rabbit hole of complexity, but for most personal investors, it doesn’t need to be that difficult.
Today, I generally ask myself six questions about any investment that I’m considering. In truth, I don’t consider new investments very often at all, as I subscribe to a “buy and hold” strategy. Once my money is in an investment that survives these questions well, I don’t really have any reason to move it.
Here are the six questions I ask myself about any investment.
#1: Do I Understand It?
For me, the threshold of understanding something is that I can explain it in one sentence and then answer follow-up questions on any aspect of that sentence. If I can’t do that, then I don’t understand it.
When I first started looking at investments, I really had no idea what they were at all. For example, my understanding of a “target retirement” fund was that it was something that you put money into if you were going to retire in a certain year, which is true, but any further understanding crumbled under any further questions.
So, what actually is a target retirement fund, then? It’s a mix of investments that’s designed to provide a high average annual return with low variance at the target date of the fund. How is that done, then? (Hey, look, a follow-up question!) It mixes several investment types in various amounts (depending on the exact fund, this will include stocks, bonds, real estate, possibly precious metals, and other things in varying amounts) so that it’s fairly high-risk and high-reward when you’re far from that date and it slowly shifts to lower-risk and lower-reward when you get closer so that you don’t lose those earlier gains at the last minute to a market hiccup.
If I cannot understand an investment to the point that I can explain what it is in a succinct way like that and also handle follow-ups, I won’t put my money in there.
Having said that, I don’t need to know everything about an investment. That’s actually impossible – you’ll just find yourself going down an endless rabbit hole of details. I just want to be able to understand it well enough to explain it simply and handle an initial wave or two of follow-up questions.
How do you get those follow-up questions? For me, the source of those questions is my wife. She wants to know those kinds of things and is always asking for details like this.
What if you don’t have an immediate person available who can ask those kinds of questions? Honestly, I’d look for the person in my social network who would seem to have the most experience with such things without also having a business motive and talk to that person. Take them out to lunch and then ask them for some insight into your investment plans. They’ll ask you questions and if you can’t answer them, then it’s a sign that you need to look into things more carefully.
#2: The Expense Ratio and the Transaction Fees
This is basically the “cut” that the investment house takes each year out of your investment. It’s how they make money.
So, for example, let’s say that you have an investment that has a 1% expense ratio. That means that, over the course of a year, the company that runs that investment is going to take 1% of the value of that investment for themselves.
On the surface, in an investment that typically grows by 7% a year, that doesn’t seem like a big deal, but it adds up to a lot of money over time. You’re essentially knocking that 7% return down to 6%, which means you’ve shifted the number of years it takes for that investment to double from 10 to 12 years (roughly). Over the long haul – say, forty years – the 7% investment will be worth about 60% more than the 6% investment. That’s likely hundreds of thousands of dollars just due to the expense ratio.
The transaction fees, on the other hand, are a one-time fee that’s charged to you as soon as you buy into a fund. This is often a commission to the person who sold you the fund or a brokerage fee of some kind.
Generally, when you have someone else invest for you, there are transaction fees involved; when you do most of the work yourself and go directly to the source of the investment, you eliminate transaction fees.
So, for example, if I went down to my local Edward Jones office and made an investment of some kind, there would be a transaction fee involved because the broker/investment advisor there would earn some money from the transaction. On the other hand, if I went to Vanguard.com and invested directly with them into a Vanguard fund, there wouldn’t be any transaction fees.
I prefer no transaction fees and the lowest possible expense ratios. For me, this is perhaps the most important factor when buying into an investment. As I’ve stated many times, I don’t really believe that anyone can consistently “beat the market,” so what I try to do is look for investments (usually index funds) that “match the market” – something that I figure out from step #1 when I’m trying to explain the investment – and then I look for ways to get index funds without fees and with the lowest possible expense ratios. This is what Vanguard specializes in, so I tend to take my money directly to them and buy into their index funds for almost all of my investing needs.
#3: The Average Annual Return
Honestly, the first two factors are the most important ones for me, but I do look at the remaining four factors when comparing somewhat similar investments.
The average annual return is simply how much that investment has returned to investors each year on average since the investment launched. While you can never perfectly gauge future returns based on past performance, the average annual return does give you a solid way of assessing differences between seemingly similar investments and it does give you a thumbnail sketch of what you can roughly expect from it.
I don’t simply chase the funds with the highest average annual return. I mostly just use it as a way to compare funds that seem similar to me, meaning that I describe them (remember #1) in a similar way.
As a very general rule, the higher the average annual return, the higher the volatility (which we’ll talk about in a minute). This is basically just a fancy way of saying “low risk, low reward; high risk, high reward.”
Let’s move onto volatility and talk a little more about that.
#4: The Volatility in That Return
This is the one that’s perhaps the hardest of all to figure out here, and it’s the one part of all of this that requires real number crunching since most websites and online tools don’t really calculate this. If this section is a little complicated for you, don’t sweat it – it may be the least important factor of the six.
All I do is I go and get the closing balance of an investment each year over the lifetime of the investment, then I fire up Excel and do a simple calculation as described here:
To calculate volatility of a given security in Excel, first determine the time frame for which the metric will be computed. A 10-day period is used for this example. Next, enter all the closing stock prices for that period into cells A1 through A10 in sequential order, with the newest price at the bottom. In column B, calculate the interday returns by dividing each price by the closing price of the day before and subtracting one. For example, if a security closed at $5 on the first day and at $6.50 on the second day, the return of the second day would be (6.5/5)-1, or .3, indicating that the price on day two was 30% higher than the price on day one. Volatility is inherently related to standard deviation, or the degree to which prices differ from their mean. In cell C10, enter the formula “=STDEV(B1:B10)” to compute the standard deviation for the period.
I’m looking for that standard deviation, which essentially tells me how much the annual return could reasonably change from year to year. So, what I might do is take the closing balance at the end of each of the last ten years and use those numbers as described above. Let’s use the Vanguard Total Stock Market Index as an example. Here, I’m taking the end balance at the end of each year plus the yield for that year (the dividends that it paid out), and we’ll just look at the last five years to keep it simple.
12/31/2011 – $31.30 (plus 2.01% yield) – $31.93
12/31/2012 – $35.65 (plus 2.09% yield) – $36.40
12/31/2013 – $46.69 (plus 1.81% yield) – $47.54
12/31/2014 – $51.60 (plus 1.78% yield) – $52.52
12/31/2015 – $50.79 (plus 1.94% yield) – $51.78
The standard deviation of the annual returns over this period is 13.2% (calculated using Excel and the STDEV function, explained above), which is pretty high. (A quick note: in the real world, you should use as much data as possible to calculate the standard deviation, so I would actually use the full history of the fund and use the ending balance of each year to calculate the standard deviation, not just five years – five years is a simple example.)
What that means is that, in a given year, I can pretty confidently expect the average annual return to go up and down by 13.2%, which means that a return one year of 10% might see a return the following year of -3.2% and that’s completely normal – in fact, that’s as normal as it gets. Some years might see less change than that while others might see more, but 13.2% is the standard change. I can completely expect that investment to go up 13.2% or down 13.2% (or less) in a given year, and that occasionally it’ll be more than that.
I would then compare it to the same exact results from other, similar investments. What is their volatility?
In general, if an investment is very long term, I want the highest average annual return as I can get – that’s over the long haul of more than 10 years. If I get to the 10-year mark, I want the highest average annual return minus that calculated standard deviation for volatility. I want that to be as high as possible for shorter-term investments.
This is a very simple calculation, of course, but it shows me what I need to know, which is a thumbnail sketch of how relatively risky an investment of mine is over the short term. Investment professionals use much more nuanced calculations to look at variance and change in stock prices over time, but this simple calculation is enough for me to get a rough idea of what’s going on, which is enough for my purposes.
The liquidity of an investment is simply how easy it is to turn that investment back into cash with minimal penalty.
Money in your checking or savings account is very, very liquid. All you have to do is make a withdrawal.
Money in the stock market is also pretty liquid. You can just sell those stocks through your investment house and have cash from that investment within a few days.
Money in a retirement account might be able to be retrieved quickly, but it usually comes with a stiff penalty for early withdrawal, so it’s a little less liquid.
Money in real estate might not be very liquid at all, as you need someone to buy the property in order to be able to sell it and that process can take a while. The same is true for things like art or other collectibles.
When you invest in yourself, such as through a college education, that investment isn’t liquid at all. You can’t simply sell your college education to get a return on your money – it’s now a part of you and can’t directly be sold.
In general, the more liquid an investment is, the better. The easier and faster it is to convert that money into cash with little or no penalty, the better it is for you solely due to convenience.
Remember, there will come a time where you need the money you’ve invested, and when that time comes, liquidity is going to be very important to you. It might not seem like a big deal initially, but that moment when it becomes a big deal, it’s a huge deal.
I tend to be wary of investments that aren’t very liquid unless I’m buying them for other purposes. For example, I wouldn’t mind owning a rental property because it’s returning some income to me while I hold it. On the other hand, I’m going to be very careful about investing in education because unless I can get a better job, it’s not going to be a worthwhile investment. (Sure, it might be good for personal enrichment, but that puts it closer to a hobby or entertainment.)
#6: Tax Benefits
Whenever you sell an investment, you’re going to be hit with taxes on that investment, usually in the form of long term capital gains tax. If you buy an investment for $100,000 and then sell it for $250,000 a few years later, you’re going to have to pay capital gains tax on the $150,000 you earned, and that might be as much as $30,000 handed over to the government. Ideally, you want to avoid that tax (or minimize it) in order to keep that money right in your pocket where it belongs. There are several ways to do that.
The most common way is to save in a tax-advantaged retirement account, like a 401(k) or a Roth IRA. In general, Roth accounts are funded with money out of your pocket today but you don’t have to pay any taxes on the money you earn inside that account provided you follow the withdrawal rules (waiting until you’re at least 59 1/2 years old is the big one). Other accounts, like a 401(k), work in the opposite direction, meaning that you don’t have to pay any income taxes on the money you put in to begin with, but you pay upon withdrawing the money (when your income is likely lower and thus you’re paying less in income taxes).
There are other tax advantaged accounts out there for other situations, like a 529 college savings account (which is like a Roth IRA except the tax-free withdrawals occur when you use the money for education) or a health savings account (the same except for health care expenses).
There are still other investments with special financial benefits, like municipal bonds which can avoid some types of taxes depending on the offering, but they often have lower returns to begin with and that counterbalances the tax benefits for most people.
Taxes can take a real bite out of your investments if you’re not careful. The thing to always remember is this: unless you’re using a special account, you’re going to almost always have to pay taxes on what you earn, which eats into your returns. That’s why a Roth IRA is such a good deal.
For an individual investor like myself who isn’t incredibly wealthy, reviewing and understanding these basic factors tells me almost everything I need to know about an investment and gives me enough to go on to make decisions on my own.
If you want to understand these factors better, I recommend hitting the library and checking out some good books on investing, such as The Bogleheads’ Guide to Investing by Larimore, Lindauer, and LeBoeuf. The more you learn about investing, the easier it is to make sensible investment decisions on your own behalf.