How to Evaluate Investments

In the financial sense an investment is the purchase of a monetary asset that is expected to increase in value over time. When you buy stocks or bonds, place money in a managed index fund or get into the real estate market, you are essentially putting your money into an asset class that you believe will generate wealth for you in the future. Therefore to properly evaluate an investment, you need to consider in the broadest possible terms the reasons behind choosing one financial asset over another. Some measures to do just that are listed below.

Assess the Possible Return on Investment

One of the defining characteristics of any investment is the potential for an exceptional return. After all, the point of buying into an investment is to use the money you have to generate even more money for you in the future. There are different ways to assess the expected return on an investment. For instance; a bond pays a stated interest rate at specified intervals over time, while a stock can either increase in value thereby producing capital appreciation which is a store or value, or pay you dividends which is another form of value. Since there are varying ways to assess the return on an investment each one must be judged according to its own criteria but an overall yield or possible interest rate may be determined to make different investment classes comparable.

Estimate the Risk Involved

In the same way that each type of investment yields a different return, each investment is also associated with a different level of risk. There is a close relationship between risk and reward or return. Generally, the greater the risk, the greater the expected return because a higher reward is necessary to entice investors to place money in situations where there is high risk. It is extremely important to know your risk tolerance before entering into any investment because while it should be understood that some risk must be accepted to achieve a return, you should not place a large percentage of your money in an investment that has a much greater risk factor than you are comfortable bearing.

Compare the Investment Against Other Options

When you have the information on both the potential for return and the associated risks it is time to compare your options. The best course of action is to choose an investment that offers more return for less risk when compared to competing uses for your money.

Identify Your Personal Goals

The final step to evaluating an investment is to check that it is in line with your personal goals. If you plan on using your money to make a down payment on your first home it probably does not make sense to enter into an investment that locks your money down for an extended period regardless of the return. This is unique to each individual so you must be able to figure out your timelines and which investment is the best for your situation.