Eleven questions to ask when evaluating an investment opportunity
Some people do it by poring over company data: earnings reports, balance sheets, income statements and the like. Some people look at stock tables and try to figure out which way a stock will go next. Others seek out professional opinions – broker white papers, pundits on TV or the commentary of well-known, successful investors. And more than a few operate by “gut,” relying on little more than intuition or a vague sense of what they think is going to work.
Truth be told, any of the above methods can sometimes be effective ways to evaluate an investment opportunity. But if you’re like most snowbirds, and rely on your investment portfolio to fund a long and fulfilling retirement, you want something better than that. When it comes to deciding which opportunities to put your money into (and perhaps more important, which ones to steer clear of), you want a process that’s reliable, doesn’t take up too much of your time and is based a lot more on carefully considered logic rather than dumb luck.
Here are some important questions that can help you do that. No, the following isn’t an exhaustive list of everything you need to think about when considering an opportunity, but they’re a good starting point. By thinking carefully about these questions, you can “pre-screen” investment ideas and quickly identify which opportunities deserve further analysis and consideration, and which don’t.
1. How does this investment fit into my overall financial plan?
First things first: when you come across any investment opportunity, you need to determine a reason for including the investment in your portfolio. What purpose does this investment serve? What need does it serve? What will it allow you to do or accomplish, either now or in the future? How does it fit with your overall investment strategy, or your larger financial plan?
There are, of course, many possible answers to these questions. Perhaps the opportunity exposes you to an asset or industry that’s growing strongly with a bright future ahead. Or perhaps it offers you some much-needed diversification into a different investment geography, or economic industry, or asset class which you didn’t previously have in your portfolio. Maybe the investment fulfills your need for additional income from your portfolio. Or perhaps it’s a way of swapping a somewhat volatile asset out of your portfolio and replacing it with something that’s more of a ‘steady as she goes’ type of investment. Or perhaps this investment is simply a vehicle to make money; you see an opportunity to buy an asset at a low price today, and sell it for a higher price in the future.
Any or all of these can be valid reasons for investing – it really depends on your financial objectives, as well as your overall tolerance for volatility. But keep in mind that, as your life changes, your definition of “fit” will change with it. Sometimes that means taking another look at an opportunity that no longer aligns with your life goals, or with the way you feel about risk and reward.
2. What’s the financial overview?
Next, you’ll need to take a look at the financial case for (or against) the investment, and get a broad understanding of how good the opportunity really is. Don’t have a PhD in finance? Not to worry: the following questions can function as a “litmus test” to help determine whether the opportunity you’re looking at is worth digging into deeper.
- How does the company or asset make money for its investors?
- Is the product, service or asset in demand? Why?
- How has the company or asset performed in the past?
- What does the future look like? Is the company or asset positioned for growth and/or increased profitability?
- How does this company fit within its industry? What’s the competitive position?
- How is the industry or asset class doing as a whole?
- What are some of the obstacles and challenges that the company or asset faces? Are these surmountable?
- What’s the “best possible” result, if nearly everything goes right?
- What’s the “worst possible” result, if nearly everything goes wrong?
- Am I being fairly compensated for the risk I’m taking on? Does the potential upside outweigh the potential downside?
Some answers will require you to make some assumptions about the company’s future. Others can be found in annual reports, investment analysis and other commentary.
3. What exactly makes this an “opportunity”?
There’s a big difference between investment ideas (which are fairly common) and investment opportunities (which are more rare). The difference comes down to a “catalyst”: an event or situation or change that will cause a company or asset to be re-priced. The difference between the price of the asset now (pre-catalyst) and after (post-catalyst) is where investors make their profits. Determining what exactly that catalyst is, how likely it is to happen, and when it will happen is a critical part of evaluating any investment opportunity.
There are many catalysts that can drive a re-pricing of a given company or asset:
- market conditions have shifted in the company’s (or asset’s) favour;
- a broad downturn in the overall market is punishing an otherwise excellent company (or a particular asset) unfairly;
- economic, regulatory or political events have turned in favour of this company or asset;
- the company/business model/asset/geography is understudied, overlooked or poorly understood;
- the growth prospects or future outlook for this business (or the country in which it operates, or the entire industry or asset class you’re looking at) has changed, or is somehow underappreciated/miscalculated;
- the management team has a new strategy to which the market isn’t paying attention just yet;
- the company has expanded recently into new markets, or an asset is now attractive to more people than before; and/or,
- the company has built a sustainable competitive advantage that should help it earn operating profits far into the future.
Again, this list is just a starting point – you may be able to identify several other potential catalysts, and it’s entirely possible that the opportunity which you’re looking at has more than one catalyst. But if you’re having trouble identifying any catalyst at all, or if the one that you do identify is overly complex or difficult to understand, or doesn’t seem all that realistic, it could be a sign that the opportunity isn’t all that it’s cracked up to be.
4. What could go wrong?
Perhaps the most important question on this list. After you’ve examined the possible upside of the opportunity, it’s time for an honest, eyes-wide-open assessment of the downside. This is where many investors fall short, as the excitement and exhilaration of uncovering a chance to make money blinds them to the risks and dangers inherent in that opportunity.
Ask yourself: what risks does this company or asset face? What are all of the things that must go “right” for this opportunity to be realized? What are the possible ways in which your catalyst (discussed above) could be delayed – or derailed altogether? What happens to the opportunity if the economy enters a recession, or if the stock market suffers a downturn? What if management makes a series of value-destroying decisions? What if competition heats up, or the company’s products somehow become obsolete, or if some kind of structural change in the way the world does business suddenly destroys demand for the asset that you’re looking at?
Here’s another thing that could go wrong: your excitement could turn to anxiety, as your opportunity leads you into more volatility than you can stomach. Whether you end up making money on it or not, an opportunity that keeps you up at night, forces you to constantly check and recheck your portfolio, or generates a sickening feeling in your stomach can’t truly be considered right for you.
These aren’t easy questions to answer – it often requires a bit of homework to uncover the risks and dangers, as well as a good deal of thinking before you can really understand how much risk you’re willing to accept in your quest for returns. But it’s far better to be honest with yourself and think of the potential negative side now. By the time you’re knee-deep into it, it’s too late.
5. Is the timing right?
Timing is an issue that’s sometimes overlooked when it comes to investing in a new opportunity. A given opportunity could be perfect on paper but, if uncontrollable economic circumstances are looming on the horizon, or your own personal circumstances interfere with your ability to capitalize on the opportunity – then that changes the investment equation entirely.
Ask yourself: is now the right time to buy into this opportunity? Will it still exist tomorrow, or in a few months, or a year from now? Think about the current outlook for the business, or the industry which you’re focused on: are there any immediate changes or disruptions or “evolutions” on the horizon? Are there issues that have been cleared up recently, pushing the opportunity into “high gear”? Or are there challenges that might delay a catalyst and put the opportunity on pause before it really starts making money?
Once you’ve thought about those questions, ask yourself whether the timing is right for you: will seizing this opportunity interfere with your ability to pay the bills, cross items off life’s bucket list or take advantage of other opportunities? Will the opportunity demand more of your time, effort and money than you’re willing to give with all that you have going on right now?
At the end of the day, no one has a crystal ball and it’s darn-near impossible to tell if the timing of any given investment is “perfect.” But the exercise is still valuable; giving some thought to what might make timing ideal (or less so) can help you zero in on some of the factors that will lead to the opportunity’s ultimate success.
6. What are other people saying?
Remember those wise old words about there being two sides to every argument? The same applies to investment opportunities: there is usually one side that believes in the opportunity wholeheartedly, and another that’s more skeptical, or even downright hostile to the idea. Before you make up your mind about which side you’re on, it’s a good idea to listen to both perspectives.
Indeed, this ability to seek out and listen to both sides of the investment argument is a critical factor behind long-term investment success. By forcing yourself to acknowledge and digest perspectives that diverge from your initial “take” on an opportunity, you keep yourself from becoming blind to “what ifs” and less-than-ideal outcomes that can sometimes be hard to see in the face of the excitement and optimism.
Ask yourself: what are the contrary opinions regarding this current opportunity? What’s the “glass half empty” analysis? What happens to your projections when you factor in more conservative growth and revenue estimates than the one you’re looking at right now? Is there anything in those opinions that make you reconsider your own? Or does the opportunity look just as good as it did before? What (if anything) are people missing?
The Internet has made it possible to take in a wide range of investment opinions and analyses from a variety of research firms, pundits, journalists and financial analysts. Finding and evaluating them can be an essential defence against emotion-driven investing, and can be an important “gut check” that can help protect your portfolio from unforeseen problems.
7. How might this opportunity impact my income?
Some investors aren’t all that concerned with income – they’re in it for long-term capital appreciation. But most snowbirds rely to some degree on their portfolio for basic cash flow, so it makes sense to view every investment opportunity you come across from this perspective.
With some investments, this question is easy to answer. When buying a government bond, for example, or a GIC, or stock in a dividend-producing company, simply determine the interest or dividend payments it provides, and there you go – that’s the impact. But with other assets, the question gets a bit more complicated. A rental property is a good example. Usually, the goal of investing in a rental property is to generate income in the form of rent. But most of the time, the purchase requires a sizeable down payment (typically 20% or more of the purchase price). And, of course, most investors will need to make ongoing monthly mortgage payments, as well as property tax, renovations and repairs, and other associated costs. Sure, you could get a sizeable portion of that outlay back in your monthly rent. So how exactly will such an investment impact your income? You’ll have to do the math to be sure.
By no means are we pooh-poohing rental property. It’s just that with some investments, tying up a significant amount of your capital, as well as paying monthly investment loan payments and other associated costs, can have an income impact that’s not immediately obvious when you’re first looking at the opportunity. So, make sure that you take a look now.
8. What’s my exit strategy?
Ask any experienced investor: the decision to buy an investment is usually a lot easier than the decision to get out. While most “buy” decisions are carefully thought-out, with detailed rationale and analysis behind them, “sell” decisions are often the opposite: taken quickly, intuitively and emotionally. Spending some time defining your exit strategy now can be a good way to make sure that those emotions don’t derail what would otherwise be a successful investment.
So ask yourself: what exactly does “success” look like with this opportunity? How much profit are you looking for here? Is this a “buy and hold forever” type of investment? Or a short-term trading opportunity? What signals or criteria will you be looking for which will tell you that it’s time to take profits and move on? When economic or market conditions change for the better? When the price reaches a certain target? When your expected catalyst plays out? Something else?
Another question to ask about your exit: will you be able to get out when you want to? With stocks, most bonds, mutual funds, ETFs and other marketable securities, this isn’t typically an issue – all it takes to cash out is few clicks of a mouse or a quick call to your advisor. But with assets such as real estate, a locked-in GIC or an investment in a private business or hedge fund, exits can get complicated. How long would it take you to sell that rental property if you had to? Could you handle any emergencies if you tied up your cash in a three-year, locked-in GIC? Are there strict limits regarding how, when or how much you can sell your position in that hedge fund?
If your portfolio is sufficiently large, or if you have other ready sources of cash, maybe these questions don’t matter too much. On the other hand, maybe they matter so much that you need to reconsider the opportunity entirely. Either way, it’s a good idea to think about the question and make sure that you know exactly how your finances and your lifestyle might be impacted if you can’t get to the exit as quickly as you’d like.
9. What are the tax implications?
Taxes are usually the last thing we think of when we find an exciting opportunity. But the fact of the matter is, taxes can completely change the profits that we realize on any given investment – which can have a dramatic impact on how we view the opportunity itself.
If you’re considering an investment inside a registered account (RRSP, RRIF, TFSA, RESP or similar), then tax issues aren’t usually a big problem. And, if you’re thinking about investing in what we might call “well-known” assets (publicly traded stocks, bank-issued GICs, government bonds and so on), then it’s usually pretty easy to get at least a general sense of what you’d owe under normal circumstances.
The further you stray from these areas, however, the more complex the tax picture can become. The classic example for snowbirds is, again, a rental property: the tax rules that make owning your principal residence so attractive are very different with a secondary property. And, of course, if you plan on renting your property out for part of the year, you’ll have to be aware of the tax rules for declaring rental income as well. If the property you’re considering is south of the border (or in another country), things can get really complex, with complicated tax rules skewed in favour of local homeowners at the expense of cross-border investors.
Bottom line: before you jump into any opportunity, make sure that you know what to expect when it comes time to pay the taxman. Consult with a qualified professional accountant or tax lawyer and find out what the rules are, and whether those rules change your view regarding how much of an opportunity there actually is.
10. What are the OTHER impacts of the investment?
No investment exists in a vacuum. Every stock, every bond, every rental property, every gold bar, every long-lost Picasso stashed in your attic exists in the context of the world around it. And that context can have major implications on many aspects of your finances, your lifestyle and, increasingly, the world itself.
Before you jump into any opportunity, ask yourself what economic, political, or cultural ideas you might be supporting by putting your money behind it. By buying this investment, are you implicitly lending financial support to a company or industry or organization or issue that doesn’t reflect your personal values? Will this investment make the workplace, the community, the world a better place? Worse off?
These aren’t right-or-wrong questions – it’s up to you to determine what implications, issues and causes are important to you. And no one but you can tell you where your individual “line in the sand” is with respect to these implications, or when exactly a particular opportunity crosses your personal boundaries when it comes to the environmental, social and/or political impact it makes on the world. But many investors are increasingly giving some serious thought to these issues before they put their money on the table. You should too.
11. What other financial priorities do I have?
Assuming that you’re not a billionaire, there’s most likely a limit to how much money you can put into any investment opportunity. And, for every opportunity into which you put money, in all likelihood, that means fewer dollars available to channel into other priorities, other interests and other pursuits.
As the last item to consider before you say yes to any opportunity, ask yourself this: how might your investment affect your ability to accomplish other things on your life’s to-do list? Would it mean putting off other financial priorities – building up a cash reserve, contributing to a grandchild’s tuition or buying a dream condo in your favourite sunbelt destination? Would you need to delay or redefine some goals on your bucket list – an around-the-world cruise, or that new car you’ve been dreaming of? If you determine that these other to-dos take priority over whatever opportunity you’re considering, you shouldn’t feel guilty about it. There will be other opportunities. But you’ve only got one life to live.
We’ve said it before, and we’ll say it again: money is a tool, and your investments serve your life, not the other way around. If you find yourself considering an opportunity that would require you to miss out on the things that really matter simply because you want “more,” – well, consider that the greatest missed opportunity of all.