This is a common question modelers ask themselves. It can be quite a conundrum, one that can be wrestled with for days, weeks, sometimes years before starting out down a given path. There's no right or wrong answer, no good or bad - it is a matter of preference and personal interest, plain and simple. I have a good friend that has been trying to sort out an era to model, along with a layout type, for over a year now, and he's no closer to figuring it out than he was at the start. So how DO you figure it out? I think there's a number of factors that you have to consider, starting with conversations about the layout.
1. How much space do you have to use for your layout? Do you have an entire basement or attic, which lends itself to a large mainline style operation, or a spare bedroom suited to a switching layout? Sure, some of the track-planning special issues out there would lead you to believe that you can stuff an entire mountainous coal branch in a 10 x 10 room, and you probably can - if you don't want to be able to stand next to someone!
2. How much time do you have to put toward the layout? If you're retired, then great - you might be blessed with a lot of free time. If you have a wife & kids though, don't count on being able to work on the layout for more than a few short hours a week.
3. How much money can you put toward the layout? Pretty self-explanatory; room prep ( lighting, paint, heat, wiring, finishes ) alone can set you back a pretty penny before the first piece of benchwork is cut. Smaller layout = smaller budget.
As Murphy's law of model railroading will tell you though, you can never have enough space, time, and money all at once. There's a compromise in there somewhere though - for me it was a 10 x 10 room off the back of our house that needed some paint and lighting work. It works for me, my family, the house, and my budget. If you don't even have a room, then think about a Free-Mo module, or a diorama. They both get you into the groove of building something and don't take up much space at all.
So now that you know a direction for your layout ( if you're building one ) sort out the railroad you want to model. For most people this is the easiest question to answer. Perhaps you grew up by the tracks of a certain railroad, or saw photos in magazines that have inspired you. Keep in mind the availability of models and your abilities as a modeler while making this decision. For example, if you're thinking of modeling an obscure shortline, then you should also be sure you're either capable of custom painting your own locomotives & rolling stock, or willing to pay someone else to do it for you! Once you know the railroad(s) you want to model, you can establish the era for your efforts. You'll want to consider model availability, accessibility of information ( if you're going with a prototype ) including reference photographs, and frankly what will provide the most enjoyable experience for you throughout the process. After all, if it isn't fun, then it isn't really a hobby.
Do you want to model history? If so, how far back does your chosen railroad go, and what time period sparks the greatest interest for you? For me, this was right around 1980 - Conrail was only 4 years old, there's still plenty of predecessor paint schemes untouched, LOTS of weathering opportunities, and there's a certain grit and grime to that era in most of the photos I have referenced.
Or....
Do you want to model "today"? A lot of folks go this way, but few excel at the concept like Eric Brooman's "Utah Belt", where locomotives, rolling stock, signalling, etc all are maintained as if it were TODAY, every day, right down to the retirement of equipment, just like a real class one line.
Taking all these questions into consideration, there is yet another option, that of "Protolancing". Tony Koester has discussed this in his books, the modeling of a plausible scenario, using realistic paint schemes, operating methods, and appropriate equipment. This theory is what allows me to operate D&H equipment side by side in Geneva NY, over a hundred miles from the nearest D&H tracks! It never hurts to make up the story of your railroad as a part of this process, and writing it out is a great way to shake out the particulars of your protolanced operations.
Seems like a lot of work to go through just to build a model railroad, doesn't it? For some, this process takes minutes, for some it will take much longer. At the end of the day it comes down to how realistic you want your layout and modeling efforts to be. I encourage you to think through each decision carefully, utilizing your resources of time, money, and space to their maximum potential. The decisions on the particulars of the Seneca Terminal Railroad took months for me to work out, but I now have a clear vision of what this railroad will look like.