When investing, we are faced with an overwhelming menu of things to choose from. There are tens of thousands of stocks, a mind-boggling number of mutual funds and ETFs, plus a dizzying array of bonds. How can we make sense of any of this to decide what makes a good investment?
It helps to know the basic elements of an investment so you know how to compare one product to another. This may require some work, but it can often be fun to dig into the details of why one investment is better than another. Here are some key things to examine.
Most people that are far away from retirement age seek investments that will grow over time. Ideally, they're looking for investments that will allow them to build a sizable retirement fund and outpace the returns offered by a basic bank account. There are some investments, such as stocks, that historically rise in value and are great for younger investors. Mutual funds and ETFs can offer solid growth as well. Bonds, however, are more likely to offer lower, but more stable returns.
As you become savvier in grasping the inner workings of specific investments, you can become skilled at knowing when an investment is undervalued and perhaps poised for big growth — or overvalued and ready for a price decline. Understanding the growth potential in certain investments can help you find the right mix for your individual portfolio. (See also: 9 Ways to Tell If a Stock Is Worth Buying)
If you don't know a lot about a stock investment at first, it helps to learn what the company does to make its money. Companies are grouped into sectors based on the type of business they operate in; within sectors, there are smaller segments called industries. Typically, stocks are grouped into 11 different sectors — including health care, financials, energy, and consumer staples, to name a few — and there can be anywhere from two to 15 industries in each sector. A well-balanced stock portfolio will have some exposure to all of these sectors and as many of these industries as possible.
When investing, it helps to learn how these sectors perform compared to the broader stock market. Some sectors perform better than the market, while others underperform. Some are resilient in tough economic times, while others are more vulnerable to bad news. Understanding these industries can help you make smart comparisons when evaluating stocks.
Stocks are usually categorized by size, also referred to as market capitalization. A company's market capitalization, or market cap, refers to the value of all outstanding shares (which is its stock price multiplied by the total number of shares outstanding).
There are large-cap stocks, which comprise the largest publicly traded companies. There are mid-cap stocks, which are medium-sized firms. And there are small-cap and even micro-cap stocks, comprising smaller companies. These categories are also called asset classes.
Generally speaking, large-cap stocks offer solid, steady growth potential for shareholders. Shares of smaller companies can offer bigger returns, but may also be riskier investments. Understanding the unique characteristics of stocks in each asset class can help you make comparisons between investments and find stocks that make sense for your financial goals.
Stocks of smaller companies can be riskier than some other investments. Understanding risk — and your own tolerance for it — can help you compare investments with confidence.
It's important to note that the potential for higher returns comes with the potential for higher risk. Finding that risk-reward sweet spot is the key to successful investing. Too much risk can result in you losing a lot of money. Avoiding risk altogether may prevent you from getting the returns needed to reach your financial goals.
Volatility and risk go hand in hand. When an investment goes up and down in value rapidly, we often say it's a volatile investment. There are ways to make money off that volatility, but for most investors, it's best to see steadier, consistent returns. (See also: How the Risk Averse Can Get Into the Stock Market)
Companies make money. They also spend it. When companies make more money than they spend, that's usually a good thing for everyone, including investors. This extra money is often referred to as net earnings. And as an investor, you want to see earnings increase over time.
When comparing two companies in the same industry, it can help to examine earnings to see which may be doing better financially. But it's also important to look at earnings in the context of a company's size. To do this, simply take the earnings total and divide it by the number of shares outstanding. So, a company with $9 million in earnings and 20 million shares would have earnings per share of 45 cents. (See also: Beginner's Guide to Reading a Stock Table)
Sometimes, just paying attention to the headlines can help you grasp whether an investment is a good one or not. Financial news can let you know of macroeconomic trends that may help or hurt certain investments, and update you on specific news regarding companies or products. When trying to decide between investments, do a quick news search to see if there's anything big you need to know. You don't have to go overboard; you can overwhelm yourself reading financial magazines and watching CNBC all day. But staying generally informed can certainly be helpful.
Many companies choose to distribute earnings to shareholders on a quarterly basis. This is great if you are a shareholder, because it's free income just for owning shares. When examining dividends, you should look at both the amount of the dividend and the "yield," which is the amount when compared to the share price.
For example, a company may pay shareholders 50 cents per share they own every quarter. That's the dividend yield. If shares of the company are priced at $35, the yield is about 1.4 percent per quarter, or 5.6 percent annually. When examining dividends, look to see if a company has a history of maintaining or even increasing dividends each year. If they do, that's a sign of a company on strong financial footing.
Keep in mind that if a company doesn't distribute dividends, that's not necessarily a bad thing. Many fast-growing companies choose to instead reinvest their earnings into business operations, and this can often help boost growth and make the company more valuable over time. Amazon may be the best example of a strong company that does not pay dividends.