Image source: Accenture. 

According to Cisco (NASDAQ:CSCO), 50 billion smart devices will be connected to the internet by 2020. If accurate, it represents a more than three-fold increase in the number devices that are currently connected to the internet. As the world becomes increasingly connected, investing in the Internet of Things, or IoT, appears to be an attractive prospect. Generally speaking, the Internet of Things is the idea that connecting billions of devices to the internet will lead to productivity gains and improvements across many facets of society.

For instance, a town could retrofit traffic signals with affordable IoT devices that remotely monitor traffic patterns and adapt the timing of traffic signals to reduce rush hour congestion. A hospital could get early warning data from a patient device and dispatch an ambulance that could be lifesaving. A factory could reduce its unscheduled downtime, which improves productivity and keeps a lid on unexpected costs. A fleet of ridesharing vehicles could automatically alert maintenance crews when the check engine light turns on. The list goes on.

Because IoT is applicable in many different fields and requires many different technologies working together (e.g. sensors, antennas, cellular broadband access, and cloud computing), investors should ask themselves the following questions to zero in on the right area.

1. Is investing in the IoT right for you?

Before anything else, consider whether investing the IoT is suitable for your personal circumstances and risk tolerances. An IoT investor should understand the risks associated with investing in individual stocks, have a strong stomach for high volatility typically associated with investing in an emerging field, and not have an immediate need for the invested funds. At The Motley Fool, we generally recommend having a time horizon of at least three years when investing in stocks.

2. Where do you want to invest?

"Where" is split between the field and technology of interest. Because IoT is such an expansive industry, this may take a fair amount of time to sort out.

Some field examples include industrial settings (e.g. factories, power plants, construction, and field operations), medical settings (e.g. hospitals and medical devices), consumer settings (e.g. wearables and appliances), and public settings (e.g. infrastructure, law enforcement, and fleet management). Technologies include areas like components (e.g. chips, sensors, and antennas), connectivity (e.g. wireless LTE broadband and networking equipment), cloud computing (e.g. data center infrastructure and cloud computing services), and software (e.g. big data analytics and apps).

3. Do you understand the company?

Suppose after seeing the following table from General Electric's (NYSE:GE) Industrial Internet (what it calls the IoT for industry) white paper, you've determined that investing in the industrial internet field, looks promising:

The power of 1% savings. Image source: GE.

Specifically, you decide that focusing on the software that powers the Industrial Internet likely plays a key role in creating significant value for customers. This leads you to considering GE as an IoT investment. Last year, GE's industrial software suite produced about $5 billion in revenue. By 2020, GE aims to generate $15 billion a year in software revenue through various software initiatives, which enable users to leverage the power of the IoT to improve productivity and drive meaningful returns on their investments at industrial sites.

However, after further evaluation, it becomes known that GE is expected to generate over $124 billion in revenue next year. From this perspective, a $10 billion increase in software sales over a five year period in software may not be large enough to have a meaningful impact on the company's overall results.

Lesson learned: some companies competing in the IoT space aren't pure-play IoT investments and it only represents an incremental opportunity, which can dilute the potential upside for investors.

4. Do you understand the risks and dynamics?

Every stock carries its own set of risks that could negatively affect the underlying investment. Understanding major risks that can derail the investment thesis prior to investing can save investors from making regretful decisions. From the company perspective, common risks include a high valuation that leaves little or no margin of safety, weak financials, poor earnings, and bad management decisions. From an industry perspective, risk often comes from competition that can make it difficult to remain differentiated, disruptive technologies that make existing technologies obsolete, and falling prices that hurt industry profits.

5. Are your expectations reasonable?

Although the IoT as a whole is popularly touted as having a trillion-plus market opportunity, it's important to put the market opportunity in the context of an individual company. More than likely, after taking into account the company's offerings in relation to the competitive landscape, the market opportunity for one company is significantly smaller.

For instance, industry insights company IDC is calling for global IoT spending to grow 16.9% per year between 2014 and 2020, from $655.8 billion per year to over $1.7 trillion per year. IDC estimates that about one-third of this $1.7 trillion is expected to be spent on IoT connectivity and services. While this can certainly bode well for the likes of Cisco, it's unreasonable to expect that Cisco will have a de facto monopoly in serving IoT markets, given the fierce competitive landscape in networking and connectivity equipment.

Putting it all together

As exciting as the prospect may be to invest in the IoT, there are a lot of factors to consider before making your first IoT investment. Ultimately, finding the best IoT investments requires a solid industry, technological, and company understanding. Make sure to do all your homework before proceeding.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.