How To Choose An Investment

There is a vast sea of investment information out there— so much information, in fact, that it can be tough to know where to look. This post is going to tell you about the few key pieces of information you need to check before buying an ETF/Index or Mutual Fund and were to find that information on the internet. Let's start with some  screen shots from BlackRock's iShares S&P 500 Index, a popular ETF that has received a lot of attention in recent years.* Here's the header at the top of fund's web page—I've add the yellow comments to help things along:

  Investment Objective

Ignore the price quotes with the pretty green and red arrows and look for the "Investment Objective." This tells us the goal of the fund, and it means you can immediately rule out funds that don't fit into your strategy regardless of where the arrows are pointing.

In this case, we are looking at a true index fund—the whole purpose of it is to invest in all or most of the large capitalization companies that make up the S&P 500. If you are trying to find a way to invest in a broad range of large U.S. companies, this might be right for you. But there are all sorts of other objectives out there. You will find funds trying to track small U.S. or international companies, track only energy companies, blend stocks and bonds, minimize taxes, minimize risk (i.e. "low volatility" funds) or even maximize risk in the search for higher returns. Just make sure the goal of the fund matches your goal as an investor.

And before you actually make a purchase, be sure to download and read that prospectus—fund companies are required by law to provide it to you.

Performance and Benchmarks

Assuming the objective matches yours, your next glance should be at performance. Online fund charts now often provide you up to the minute information on the fund's price, and the chart is almost always set to show you only the last year (and often, only the last day). A fund's past success never means that you can count on it to perform in the future, but the fund's performance over the past year is especially useless. Click on the 10 year (10Y) option to see how the fund has done over a much longer timeframe. And crucially, compare your fund's performance to its benchmark.

What is the benchmark? The benchmark will be the market index that best matches up with the fund's investment objective. If the fund tracks bonds, it will be a bond index; if it tracks technology companies, it should be a technology index. The benchmark gives us a better idea of how well the fund is doing at what is designed for.

 Fees: What are you paying?

Investors routinely miss this little statistic (I couldn't even find it on Google Finance or Yahoo Finance's page for IVV), but this one is a big part of your decision. The Expense Ratio will be a percentage, and it tells you how much of the money you put into the fund will go to paying for fund management fees every year. To find out what you personally will be paying every year to own the fund, multiply the percentage by the amount you plan to invest.

In this case, I've chosen to show you one of the least expensive funds out there—you won't find many this cheap. Mutual funds on average range between 1 and 2%, while Index Funds average somewhere around .5% (it takes more work to manage a collection of stocks than have your computer track an index!).

You will find plenty of cases where two funds with similar holdings and objectives vary wildly in price, so make sure you aren't losing you money to management fees right off the bat.

Holdings and Risk

Now let's look at the bottom of the fund profile page:

If the fund has been clear and accurate with it's objectives, the holdings list at the bottom should not come as a surprise, but you should always take a quick glance at what you are buying. Does it overlap a lot with another fund you own? That's a warning sign that you may be paying for two funds where you only need one.

Now note the "Standard Deviation." This number will be a percentage, and it is meant as a quick indicator of how volatile the investment is likely to be—how much it's price will go up and down. Here we see that IVV's standard deviation is 9.58%, which is not coincidentally about the same deviation as the S&P 500 Index. Don't worry too much about how this number is calculated, just know that 9.58% puts IVV in the middle of the pack (deviation-wise) for publicly traded funds. At the riskier end are things like emerging markets, which might have standard deviations around 20% and "low" or "managed" volatility funds, which might have standard deviations of only 3% to 4%.

Standard Deviation is not the only indicator we use to determine whether an investment is risky (other common measures of riskiness include alpha, beta, Sharpe ratio, and R-Squared), but it does give the average investor some warning about how much an investment's price is likely to swing up and down.

One More Factor To Consider

If you are looking at a mutual fund, rather than an ETF, you may have to contend with minimum investments, especially if you are buying within another investment company. Check the sidebars of your fund profile to see if there is a minimum. And if you do see one, but like the fund, check the fund company's own website to see if it available directly through them without minimums.

*note that this does not constitute an investment recommendation for any of you out there—just an investment example.

Choosing An Investment Strategy

Choosing your investment strategy is probably the toughest step you will take as an investor. Not coincidentally, it is also the one investors are most likely to skip over. Like it or not, investing is a glorified form of risk taking. Despite all of the studies, spreadsheets, evaluations and computer algorithms, we never really know what will happen next in the marketplace. Since we don't have control over  all of the things that can change the fortunes of a company or its stock, we need to have a plan for what we can control—and that's where your strategy comes in.

Hot Stocks

The riskiest strategy out there is probably the most common one among smaller investors. A simple form of stock picking, it involves placing all of your money in a short list of stocks that you think might be going somewhere.

This strategy usually results in some great conversations at cocktail stories. Chances are you've overheard someone chattering about how much she made on her Apple stock. On the other hand, you are a lot less likely to hear how much she lost in Mattel last year. Ouch. Stocks don't always rise and fall so dramatically, of course. But the kind of public chatter that often convinces someone to buy a stock is the same sort of chatter than sends herds of investors rushing—and sell—all at once. If you are going in as a stock picker, be ready for the roller coaster ride.

Diversification

To avoid those wild swings, investment advisors diversify (invest in a wider array of securities) to prevent the disastrous scenario of having all of your money in one stock when it drops. In fact, mutual funds, bond funds and more recently, exchange traded funds (ETF's) were created to make diversification cheap and easy. Your ownership of fund shares mean that you "share" in a large pot of different investments.

Asset Allocation

We investment advisors don't just add more stocks to our list, though. We also use asset allocation. In other words, we put a little bit of money into a lot of different kinds of investments. Asset Allocation strategies recognize that large company stocks, government bonds and real estate trusts all respond differently to market conditions. By investing in different kinds of securities, we hope to make money even when certain portions of the market are losing or flat. This post gives you the basics on creating your own asset allocation model.

Contrarians

Whether you are investing in a single stock or creating a diversified portfolio, you are going to run into trouble unless you have a strategy in place for deciding when to buy and sell. Everyone agrees you should "buy low and sell high." The problem is knowing when an investment actually is high or low. A "contrarian" solves this by keeping track of whatever the market seems to be doing and then doing the opposite. Is Apple soaring this week? Then it's time to sell. If a stock drops, a contrarian treats this as the time to buy.

As you can imagine, there aren't a lot of true contrarians out there. There is always a chance that the stock will go just the little bit higher or lower tomorrow, so contrarian strategies often just leave investors paralyzed in the face of a decision.

Hedging With Options: Calls & Puts

This approach deserves a post of its own, if only because most investors will find it the single most confusing aspect of of the investment world. The idea of "hedging your bets" is exactly what it says. Imagine someone placing a bet and then drawing a boundary (a hedge) around the possible outcomes. If you've placed your bet on Apple stock, hoping it will continue to go up, you might also put a little money on the possibility it goes down—just in case. You could do this by purchasing (for a price) a "put." Put are contracts that give you the right to sell your Apple stock at a certain price. If you find your Apple stock has plummeted below that contract price, you exercise your option and sell the stock at the contract price, limiting your losses.

Conversely, you might decide not to buy Apple but worry that it could be going up in value. Buying a "call" option instead of a "put" gives you the right to buy those Apple shares later at the price you've agreed on. You will exercise your "call" if the Apple stock goes above the call price, which makes the stock a bargain for you.

Most investors will never directly purchase options of any kind, but you will likely have the opportunity to buy mutual funds and even hedge funds that use this as an essential part of their investment strategies.

Index Investing

Over the past 20 years or so, a more radical approach has emerged to solve the problem of timing in the stock market. Increasingly investors are using index funds to avoid questions of when to buy or sell almost entirely. Under this strategy, you follow the markets, rather than the securities in them. An index fund has a little bit of whole lot of stocks from a particular category. The most popular of them follow well known indexes like the S&P 500 or the Dow Jones. Since your index fund has shares of just about everything on the index, you are counting on particular shares to rise—just that on average the whole index goes up. Index investing is essentially a bet that the global economy will continue the pattern of long term growth we've seen historically. An index investor just sits back to enjoy the ride.

Does index investing work? Well, so far it does. We use it at Revolution Capital, and while we still can't tell you what the markets will do tomorrow, we feel good about research that shows index investing generally wins out over even seasoned experts in the long run. If you want to read more on the research into index investing, Vanguard regularly updates their research on the subject).

So which strategy is best? You will find experts out there who swear by each of these strategies, and none of us can tell you the 'right' answer. What's important is finding the right answer for you—and then sticking with it.