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The Rich Dad Guide to Becoming a Sophisticated Investor

Everything you need to know to move from an amateur investor to a sophisticated investor

Summary

• Building wealth means learning to be a sophisticated investor

• The rich focus on passive and portfolio income, while everyone else focuses on earned income

• The key to becoming a sophisticated investor? Up your financial education

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It was a wild week on Wall Street in early 2021. Chances are that even if you don’t follow the stock market, you came across any number of stories on the incredible rise of GameStop’s stock prices, and to some extent AMC and a handful of other companies.

On Friday, January 29, 2021, GameStop’s stock went as high as $380 and became one of the most traded stocks on the market. How did this happen to a mall store with a stone-age business model in the middle of a pandemic?

Hedge funds vs. retail investors

It was the result of a power struggle that has been brewing for years, the rich vs. the poor. The establishment vs. the populist.

Over the last decade, programmatic trading using sophisticated technology has allowed hedge fund managers to exact enormous profits by short selling companies that they believe will fail. At the same time, using websites like Reddit and new financial technology apps like Robinhood, amateur investors (or what the media calls retail investors, those who day trade to try and get personal gains) have quietly built a rebellion against hedge funds.

This all came to a head in early 2021.

As MSN Money wrote:

The internet has been used to prognosticate about stocks for decades, but there's never been anything quite like the Reddit community called r/wallstreetbets, also known as WSB.

WSB takes something of an internet extremist's approach to investing. Its slogan is "Like 4chan found a Bloomberg Terminal," alluding to the fringe message board and the Bloomberg computer system that is nearly ubiquitous in finance.

Amateur investors on WSB have discussed GameStop (which they refer to by its stock ticker abbreviation, GME) for years, but things changed early this year. As the price of the shares rose, more WSB posters jumped on board. "100% of my portfolio on GME because of you idiots," a person posted Jan. 10. On Wednesday, the people who run WSB temporarily made the community private and said they were "experiencing technical difficulties based on unprecedented scale as a result of the newfound interest in WSB."

There's also Robinhood, the app that is the unofficial stock trading platform of choice for WSB. It lets people trade stocks and even more exotic investments, like options, for little or no charge.

As a result, short sellers (mostly hedge funds) lost $23.6 billion on GameStop alone in the month of May of that same year. That’s what we call a bloodbath.

What can we learn from the GameStop phenomenon

You’ll always hear seasoned investors talk about the importance of control when it comes to investing. Control is the most important thing you can have as an investor. Lack of control leaves you at the mercy of market conditions. This is also why it’s riskier to be an employee than to be an entrepreneur; entrepreneurs have more control over their destiny than they would as an employee.

One of the best ways to tell if someone is a sophisticated investor vs. an amateur investor or gambler is whether they understand how to set themselves up for the most control.

In this sense, both retail investors and hedge funds are amateurs and gamblers. The GameStop occurrence was a perfect lesson in the importance of control. Make no doubt about it, it was a way for the retail investors to stick it to the hedge funds. But a reckoning will most likely come to most of those retail investors and probably at the hands of the hedge funds.

No one wants to be an amateur. If you’re going to do something, you want to be the best you can be at it...especially when it comes to your money. But the reality is that most people are amateur investors. And most likely, you are too.

This post is the Rich Dad guide to moving from being an amateur investor to a sophisticated investor.

The characteristics of an amateur investor

Usually, amateur investors have limited financial knowledge and education. They were raised to believe that debt was bad, and they do not understand that there can be good debt. They also believe the same thing about expenses and losses.

For instance, an amateur investor will talk about a company like Amazon and make jokes about how it is not profitable. They are not sophisticated enough to understand that Amazon intentionally takes losses because it is investing in growth. To them, debt, exposure, and losses are “bad” things. Ironically, while making jokes like these, they’ll gamble on a stock like GameStop because it’s going up and everyone is in a frenzy...despite the fact that the company is not growing and its financials are rocky.

As Robert Kiyosaki wrote a while back, Amazon spends money like a rich person does, that is in a sophisticated way:

Amazon has often been ridiculed for “not being profitable.” By this people meant that they didn’t post positive net income. But as Recode points out, “to know Jeff Bezos’s priorities is to know that he cares more about cash flow than net income.”

…Amazon’s lack of net income isn’t due to poor business practices or a poor business plan. Rather, it’s due to reinvestment of cash into new investments. As Molla and Del Rey write, “But isn’t a business’s goal to turn a profit? Not at Amazon, at least in the traditional sense. Jeff Bezos knows that operating cash flow gives the company the money it needs to invest in all the things that keep it ahead of its competitors, and recover from flops like the Fire Phone. Up and to the right.”

This is no different than how the rich spend their money, constantly acquiring new assets that produce greater cash flow in order to buy more assets. The chart speaks for itself, and as you can see, the growth is exponential.

As a result, Amazon has gone from a $438 million valuation at its IPO in 1997 to a $460 billion valuation today—all without being “profitable”.

To understand this requires a level of sophistication that amateur investors simply do not have. Amateur investors are much happier following the herd when it comes to investing than understanding the nuances of what makes for a solid investment.

Rather than get caught up in gambling to make a fortune in day trading, it’s important to learn how to build true wealth as a sophisticated investor.

The advantages of being a sophisticated investor

Most people are average investors. They count their chickens before they’re hatched, have no control over their investments or income, and play the averages when it comes to the markets.

If you want to be successful as an investor, you must move from average to sophisticated.

Rich dad defined a sophisticated investor as someone who understands how money works, the nuances of the markets, how to size up a company, and is familiar with the following specialties of law:

• Tax law

• Corporate law

• Securities law

While not lawyers, sophisticated investors may base much of their investment strategy on the law as they do on the investment product and potential returns.

By knowing the basics of the law, the sophisticated investor is able to employ the advantages of E-T-C, which stand for:

• Entity

• Timing

• Character

Sophisticated Investor Advantage #1: Entity

Sophisticated investors have control over the entity of their investment, which means the choice of business structure. Employees, for instance, do not usually have such control, while a self-employed person can choose from the following entities: sole proprietorships, a partnership, an S corporation, a limited liability company (LLC), a limited liability partnership (LLP), or a C corporation.

More than just having a choice, however, the sophisticated investor knows how to work these entities to his or her favor.

For instance, in the United States, if you are an attorney, doctor, architect, dentist, etc., and you choose the C corporation as your entity, your minimum tax rate is much higher than it would be for someone like me, since my business is a non-licensed, professional-service business.

By understanding and choosing the right entity, a sophisticated investor can save 20% or more in taxes. That adds up to a lot of money.

Want to learn more about entities and their advantages? Read Rich Dad Advisor Garret Sutton’s book, Start Your Own Corporation. And, of course, consult with your tax advisor for what works best for you.

Sophisticated Investor Advantage #2: Timing

Rich dad said, “Timing is important, because ultimately we all need to pay taxes. Paying taxes is an expense of living in a civilized society. The rich want to control how much they pay in taxes, as well as when they have to pay them.”

Understanding the law helps in controlling the timing of paying taxes. For instance, Section 1031 of the U.S. Tax Code allows you to “roll over” your gain in investment real estate if you buy another property at a greater price. This allows you to defer paying taxes. You can do this indefinitely if you’d like.

Another example is that C corporations can choose a different year end than December 31, unlike individuals, partnerships, S corporations, and LLCs. The advantage? A different year-end date allows for certain strategic planning as to the timing of distributions between corporations to individuals.

Again, it is best to consult your tax advisor on what the best strategy is for you.

Sophisticated Investor Advantage #3: Character

Rich dad said, “Investors control. Everyone else gambles. The rich are rich because they have more control over their money than the poor and middle class. The moment you understand that the game of money is a game of control, you can focus on what is important in life, which is not making money but gaining more financial control.”

The character of money was important to Rich Dad. He taught that there are different characteristics of income:

• Ordinary earned income

• Passive income

• Portfolio income

He said, “The poor and the middle class focus on ordinary earned income, also called wages or paycheck income—the highest taxed income. The rich focus on passive and portfolio income—the lowest taxed income. That is the fundamental difference between the rich and the middle class. That is why it’s important to focus on the character of the income you receive, not just how much money you make.”

Sophisticated Investor Advantage #4: Control

Finally, the penultimate advantage of a sophisticated investor over an amateur investor is that they have control. Again, if you are gambling on stocks like GameStop, you have zero control. If you buy a house and hope it goes up in value, you have zero control. Amateur investors hope and pray their investments go up. Sophisticated investors have a plan, can pull levers, and are much better positioned to control the growth potential of an investment. And they do so through ten controls.

The 10 controls of the sophisticated investor

Rich dad often spoke of the sophisticated investor. “A sophisticated investor is an investor who understands each of the ten investor controls,” he said. These ten controls were the key to making huge sums of money in the markets.

If you’ve been thinking of jumping into the fray and making a quick buck on what’s happening in the market, be sure to contend with these 10 controls and ask yourself if you really want to be a gambler, or if you’d rather commit yourself to mastering these ten controls and becoming a sophisticated investor who builds wealth in an intelligent way over time.

Sophisticated investor control #1: Control over yourself

“The most important control you must have as an investor is control over yourself,” said rich dad.

Most of us were taught in school to become employees. There was only one right answer, and making mistakes was horrible. We were not taught financial literacy in school. Once you leave school, it takes a lot of work and time to change your thinking and to become financially literate.

A sophisticated investor knows that there are multiple right answers to any given situation, that the best learning comes through making mistakes, and that financial literacy is essential to be successful. They do not become flustered when they make a mistake. Rather they have control over themselves to learn from and get better from mistakes. They know their own financial statement, and they understand how each financial decision they make will ultimately impact their financial statement.

Most importantly, a sophisticated investor knows when to hold back from jumping into a volatile and unpredictable market.

Sophisticated investor control #2: Control over income/expense ratios and asset/liability ratios

This control is developed through financial literacy. Rich dad taught the three cash flow patterns of the poor, middle class, and the rich.

The poor spend every penny they make and own no assets. It is simply money in and money out.

The middle class accumulates more debt as they become more successful. A pay raise qualifies them to borrow more money from the bank so that they can buy things like cars, vacations, boats, and more. As their income increases, so does their personal debt. That is what we call the rat race.

The rich have assets that work for them. They have gained control over their expenses and focus on acquiring or building assets. Their businesses pay most of their expenses, and they have a few, if any, personal liabilities.

Sophisticated investors focus their time and energy on buying assets that put money in their pockets—not chasing liabilities that take money out. It’s just that simple.

One reason why a sophisticated investor might not jump into the GameStop craziness is because they would not be investing in assets that provide cash flow. They would simply be gambling, betting the stock price would go up—but it may also crash.

Gambling can be fun, but it’s not sophisticated investing.

Sophisticated investor control #3: Control over the management of an investment

An inside investor who owns enough of an interest in the investment to control the management decisions has this type of investor control. The investor can be a sole owner or own enough of an interest that he or she is involved in the decision-making process.

The skills learned through building a successful business using the B-I Triangle are essential to this investor.

Once the sophisticated investor possesses these skills, he or she is better able to analyze the effectiveness of the management of other potential investments. If the management appears competent and successful, the investor is more comfortable investing funds.

A sophisticated investor would know they have no control over the management of GameStop and that the gains in the stock price are not related to the business performance of the company, which actually has poor performance.

Sophisticated investor control #4: Control over taxes

The sophisticated investor has learned about the tax laws, either through formal study or by asking questions and listening to good advisors. The right side of the CASHFLOW Quadrant provides certain tax advantages that the sophisticated investor uses thoughtfully to minimize taxes paid and to increase tax deferrals wherever possible.

For instance, in the United States, people on the B (business) and I (investor) side of the quadrant enjoy many tax advantages that those on the E (employee) and S (self-employed) side do not.

Much of the sophisticated investor’s income is in the form of passive and portfolio income, so they do not have to pay social insurance taxes like social security and Medicare on that money.

They can use tax laws to defer tax payments, sometimes indefinitely.

They can pay for expenses with pre-tax dollars and be taxed only on the net income.

These and many other advantages give the sophisticated investor a huge head start over those investing in the E and S quadrants.

A sophisticated investor would know that day-trading GameStop stocks for short-term gains would actually be taxed at some of the highest tax rates because it would be considered capital gains.

Sophisticated investor control #5: Control over when you buy and when you sell

The sophisticated investor knows how to make money in an up market as well as a down one. In building a business, he or she has great patience. This patience is often referred to as “delayed gratification.” A sophisticated investor understands that the true financial reward is after the investment or business becomes profitable and can be sold or taken public.

A sophisticated investor would understand they have no control over when to buy or sell GameStop. They would simply have to watch the market and make a judgment call based on how much it was going up or down, often in a given day. Sure you can make the call when to sell, but that’s not true control. No one is truthfully looking to hold onto GameStop for the long run. The market conditions force your hand on when to buy or sell.

Sophisticated investor control #6: Control over brokerage transactions

Sophisticated investors who have inside influence can direct how the investment is sold or expanded.

As outside investors in other companies, sophisticated investors carefully track the performance of their investments and direct their broker to buy or sell appropriately.

Many investors today rely on their brokers to know when to buy and sell. That is not sophisticated. It's foolish. Amateurs learned this the hard way when the popular trading app, Robinhood, eventually stopped allowing trades of GameStop.

A sophisticated investor would understand that the massive volatility of GameStop might cause a lack of control on when they could do transactions...and that they might get caught in the cold in the process. They would also understand that there are high fees that come with day-trading that compound the cost of the transactions on the tax side.

Sophisticated investor control #7: Control over the E-T-C (Entity, Timing, Characteristics)

“Next to control over yourself, the control over the E-T-C is the most important control,” said rich dad. To have control over the entity, timing, and characteristics of your income, you need to understand corporate, security, and tax law.

Rich dad truly understood the benefits offered through choosing the right entity with the right year-end and converting as much ordinary income into passive and portfolio income as possible. This strategy combined with the ability to read financial statements helped rich dad build his financial empire more quickly.

A sophisticated investor would understand that retail trading is capital gains that basically lives on the left side of the CASHFLOW Quadrant where entities and the law are not built to maximize gains.

Sophisticated investor control #8: Control over the terms and conditions agreement

The sophisticated investor is in control of the terms and conditions of the agreements he or she makes when on the inside of the investment.

A sophisticated investor would know that the GameStop situation doesn’t allow for this type of control and would put them at risk for serious tax liabilities and losses.

Sophisticated investor Control #9: Control over access to information

As an inside investor, the sophisticated investor again has control over access to information. This is where the investor needs to understand the legal requirements of insiders imposed by the SEC in the United States (other countries have similar oversight organizations).

A sophisticated investor would understand that the price of GameStop’s stock had nothing to do with what was happening inside the company and that there would be no way to have control over the access to information that influenced the stock price.

Sophisticated investor control #10: Control over giving it back

The sophisticated investor recognizes the social responsibility that comes with wealth and gives back to society. This may be through charitable giving and philanthropy. Some of it will be through capitalism, by creating jobs and expanding the economy.

A sophisticated investor would also weigh the cost of short term gains betting on crazy price fluctuations with the human impact that has on the people inside a company.

As Rajan Roy writes for the newsletter The Margins:

GameStop is a real company. It has over 53,000 employees. There's a reason you have not heard from anyone at GameStop. This must be terrifying.

GameStop's CFO is a guy named Jim Bell. I feel he might go by Jimmy B. He was formerly the CFO of the PF Chang's holding company (awesomely named Wok Holdings). He was a Naval Officer. Jimmy B. seems like the type of guy you'd want to handle such a high-pressure situation.

But when that stock starts absolutely tanking - what happens? Does it stop exactly at some reasonable enterprise valuation? That's not how momentum works. In trading, everyone loved the adage "don't try to catch a falling knife" but while everyone enjoyed the lulz on the way up (other than Melvin Capital), it will be Bell's job to catch the knife on the way down to try to keep as many of these people still employed as possible. Whatever happens, it will [be] dangerous and ugly. Real employees could lose their real jobs thanks to the lulz.

Again, gambling can be fun, but it can have real consequences both for you and for others. And it should never be confused with sophisticated investing.

You could jump onto the GameStop crazy train (or whatever the next crazy train is). But always consider the risk and the cost. You’ll come to realize your time could be better spent mastering the ten controls of sophisticated investing.

Finally, here are the three “bad” things that sophisticated investors love and amateur investors fear: debt, expenses, and losses.

Good debt, expenses, and losses

If you’re an amateur investor or entrepreneur, you can easily change your ways by investing in financial education. You can start here with some basic knowledge about what makes debt, expenses, and losses good.

As a general rule, good debt, good expenses, and good losses all generate additional cash flow for you. Sophisticated investors know this and love debt, expenses, and losses (if they’re good!). The amateur investor fears them.

For instance, debt taken to acquire a rental property that has a positive cash flow each month would be an example of good debt.

Paying for legal and tax advice that saves you thousands of dollars in reduced taxes is an example of good expenses.

An example of a good loss is the loss generated by depreciation in real estate, often called phantom loss, because it is a paper loss and does not require an actual outlay of cash. The end result is that this phantom loss becomes a gain on the tax side.

Bad debt, expenses, and losses

Conversely, bad debt, bad expenses, and bad losses all take money out of your pocket.

Amateur investors hear the words, “debt, expense, and loss,” and react negatively. Their experience does not allow for thinking of these terms in a positive way. Generally, their experiences with debt, expenses, and losses result in additional cash flowing out of their pockets, instead of into their pockets.

When they hear the word debt, they think of things like credit cards, which are used to buy liabilities like new clothes or TVs, and that have very high interest rates. That indeed is bad debt.

When they hear expenses, they think of monthly bills, which they have to work hard to pay month to month, as well as the rising cost of things like medical care. Those indeed are bad expenses.

And when they think of losses, they think of things like their 401k taking a beating in the stock market and watching their retirement funds dwindle. That indeed is a bad loss.

The ugly truth

The ugly truth of all this, however, is that it is often very difficult for the amateur investor to make the shift to see debt, expenses, and losses in a positive light—which makes it very difficult for them to invest in a way that makes them truly rich.

So, for instance, when it comes to buying investment real estate, they say things like, “Wouldn’t it be better to pay all cash?” Their fear of debt makes it hard for them to see that using all their own cash is an average way of investing because the return is so much lower. They don’t realize that by leveraging good debt, the Rich Dad fundamental of Other People’s Money (OPM), they have the possibility of a near infinite return.

When it comes to expenses like legal advice and tax accounting consulting, they decide to go the cheap way or do it themselves. They don’t have the ability to see that the potential savings of using quality services and experts can actually make them more than the initial cost.

And because they don’t know enough about the law, they can’t even imagine how a loss could actually be a gain.

Up your financial education to become a sophisticated investor

If you want to move from amateur to sophisticated investing, all it takes is financial education and the desire to open your mind to new possibilities. Start by simply joining the Rich Dad Community, where you can receive free resources and play our financial education game, CASHFLOW at no cost.

The good news (for you) is most people won’t put in the effort required. So, just by taking the next step towards a higher financial IQ, you’ll be light-years ahead of the average investor.

Are you ready to become a sophisticated investor? It starts with financial education and good coaching.

Start today.