It’s important to have standards for potential investments so you can be more objective when you evaluate them.
Trust me, it’s a lot easier to say no to a bad deal when you already know what a bad deal looks like.
There are six categories to consider when setting your standards.
- Cash up front
- Net worth return on investment
- Cash flow
- Cash on cash return on investment
- Time invested
Every investor has different tolerances for each of these categories and your tolerances combined with your financial goals determine what type of investor you are.
1. Cash Up Front
You won’t be investing in anything without some cash.
In order to buy stocks, real estate or businesses you’ll have to put down some of your own money.
Before proceeding with an investment, you must know how much money you can scrape together. This number will be the first filter you use when creating your list of potential investments.
Even a great opportunity can be stopped in its tracks simply because you don’t have the cash up front.
Tip: Sometimes looking at investments that you can’t afford will force you to get creative. You can think up new ways to pull money together or work out unusual financing terms.
2. Net Worth Return
Net worth return is the amount your net worth increases in one year, expressed as a percentage of your cash up front.
If you put $100 into an investment and after one year your net worth increased by $10 because of that investment, then you net worth return is 10% (10/100).
In the eyes of many, net worth is the most important gauge of wealth. Net worth return is the only category that should never be zero.
It’s reasonable to invest in something with zero cash flow or zero cash on cash return. But you should never invest in anything with zero net worth return.
I typically ignore any investment that expects less than 8% net worth return.
Anything below 8% should have near zero risk because you can get that just by putting your money in an index fund (like the S&P 500). That’s an 8% return for pretty low risk and near zero time investment.
3. Cash Flow
Cash flow is how much cash is being generated by your investment per month. As a self proclaimed cash flow investor, this category is extremely important to me.
Because cash is necessary for two things, purchasing more investments and supporting your cost of living. You can’t live off your investments without sufficient cash flow.
I don’t have a specific number in this category, but usually I won’t bother unless I’m getting at least $300/month.
The definite exception to this rule is cost cutting. You can sometimes cut recurring costs for free or very little money. You might only save $10 per month, but if it was quick and free to implement then I’ll do that all day!
It’s important to estimate cash flow, but the most important measure of cash flow performance is…
4. Cash On Cash Return
Cash on cash return is a way to assess how much cash flow an investment produces based on your cash up front. And it also helps predict how long it will take for you to recoup your cash up front.
I do have a minimum return number on cash flow.
I typically ignore a cash flowing investment unless it has a cash on cash return of 20% or better.
Most cash flowing investments require a significant time investment. And as such I expect a very good return on investment.
The exception here is dividend stocks. They require very little time investment, but this usually means they have a much lower return.
5. Time Investment
Time investment becomes extremely important as your portfolio grows. Particularly if you have several active investments. Your time can become more and more precious.
As a general rule, the more of your time an investment needs, the higher your returns should be.
For a passive investment like stocks, returns between 6-10% are acceptable. But if you are purchasing real estate and acting as the landlord, then you should expect significantly higher returns.
Risk is a term that gets thrown around a lot. It is difficult to quantify, but is also incredibly important to understand.
I’m not a theoretical mathematician or anything, so I try to keep my risk analysis relatively simple. These are some questions I might ask about a potential investment.
- What is the worst case scenario? How much money can I lose?
- What conditions would lead to the worst case scenario?
- If the investment becomes bad, how can I get money back out?
- What conditions would cause me to lose money?
- What do I not know?
Ultimately, I want to have an understanding of how the asset makes money and a comprehensive list of everything that can go wrong. Then I want to ask myself how I can prevent those bad things from happening.
This is also where I think about an “exit plan.” That just means you know what your long term plan is for the asset, and you know how to cash it out (or sell it) when you don’t want it any more.
Once you get a feel for your risks you can start to weigh those risks against the other factors (return on investment, time and so on).
And of course the more risk you perceive, the higher your expected return on investment should be.
Let’s analyze the risk of an example investment.
Risk assessment example
Let’s say I’m looking at purchasing $1,000 of stock in a company that sells paper in New York City.
Here are some questions and answers I might come up with:
- How much money can I lose? $1,000. Worst case is the company goes bankrupt and my stock is worth nothing.
- What conditions would lead to me losing money? If the company sells less paper, I would lose money. So if the company’s clients start trending towards paperless workflows the company could slowly go out of business.
- If the investment becomes bad, how can I get money back out? I can get money out by selling my stock shares.
How does the company make its money? By selling paper to local businesses.
What types of things would keep the company from making more money? Things like cheaper competitors, customers going paperless or changes to the cost of supplies needed to make paper.
Before buying the stock, I could do a few things to help get a better feel for my risk.
- Compare the company’s paper prices to others in the area
- Try to obtain a list of current clients and judge what their paper uses may be in the future
- Learn about the costs of the business and put something in place to monitor those costs
This is a very simplistic example, but it shows how I can begin to quantify my risk with some simple due diligence.
It’s hard to be successful as an investor if you don’t have a way to weed out the bad investments. Setting up some personal investment standards in the six categories helps narrow down the search and allows the best prospects to rise to the top.
Perhaps you want to maximize cash flow, hoping to replace the income of your day job. Or possibly you’d rather minimize risk to protect your wealth. Whatever your goals, having standards will help keep you on track.
Knowing your priorities, and setting minimum return numbers allows you to look at options more objectively.
Here are the numbers I’m using right now.
- Required cash up front can be gathered together
- Minimum 20% cash on cash return
- Minimum 35% net worth return
- Risk can be quantified and I have an exit plan
- Time investment depends on profitability, more time allowed for more profitable investments
You can frame your investment standards however you want. The most important thing is that you have a clear model to help guide your decision making process.
Stay true to your process and you will be successful!