5 Questions to Ask When Investing

Asking questions is part of the due diligence process of investing. You can choose from several asset classes, such as stocks and bonds, and hundreds of securities in each class. These securities will have different risk-reward characteristics. By asking the right questions, you can select the investments that fit your financial objectives and tolerance for volatility and risk.

Familiarity

Before you invest in a stock or a bond, ask yourself if you understand the business and the industry. For example, if you are not comfortable with technology, do not chase technology stocks just because they are doing well today. If you do not have the time to research individual companies, consider mutual funds because they offer diversification and professional management at reasonable cost. If you are familiar with fixed-income products only, look into certificates of deposit and Treasury bonds. Read the offering prospectus before investing in fixed-income products or mutual funds.

Fundamentals

Ask questions about the business and industry fundamentals because they affect long-term prices. Review quarterly and annual reports to assess a company's operating history, including revenues, profit margins, cash flows and market share. Research the competitive environment, including the number of companies entering and exiting the marketplace and the ability of companies to raise prices. Analyze the reasons behind recent senior executive departures because that can be an early indication of financial problems.

Outlook

The outlook for corporate revenues and profits is probably more important than the historical results because financial markets tend to look ahead. Publicly traded companies usually provide guidance for upcoming quarters, which stock analysts use to provide recommendations on which stocks to buy or sell and at what price. Companies with growing profits and strong cash flow can invest in new product development and spend on marketing programs to maintain or grow market share. Conversely, companies with declining profits cannot make meaningful long-term plans because they are usually trying to manage cash flow issues and remain viable.

Risks

Look into the risk factors of potential investments. For example, ask what could happen to stock prices when revenue and profit expectations do not materialize. Companies with strong cash positions and low debt levels are able to withstand financial shocks, but smaller companies with limited cash flows might have less flexibility. Deteriorating financial positions also affect interest payments on outstanding bonds, dividend payments and necessary investments in infrastructure and research. Analyze the impact on profits if the central bank starts raising interest rates or if there is a parts or labor shortage. Ask how proposed government regulations might affect operating expenses and cash flow.

Rewards

Investment decisions involve balancing risks and rewards. For example, you are not taking on any risk or expecting very much reward when you invest in certificates of deposit or in U.S. Treasury bonds. However, your reward expectations would be higher for corporate bonds and stocks because they are riskier investments. Evaluate the timetable of potential rewards because there is no point taking on higher risk if the rewards are unlikely to materialize within your investment time horizon.