Investor Lesson 12 - The Basic Rules Of Investing

One day, I was feeling frustrated about my financial progress in life. I had about four months before I was to leave the military and enter the civilian world. I had stopped all efforts to get a job with the airlines. I had decided that I was going to enter the business world in June of 1974 and see if I could make it in the B quadrant. It was not a hard decision since rich dad was willing to guide me, but the pressure to become financially successful was building. I felt that I was so far behind financially, especially when I compared myself to Mike.

During one of our meetings, I shared my thoughts and frustrations with rich dad. I said, “I've got my two plans in place. One plan is to ensure that I have basic financial security, and the other, more aggressive, investment plan is so I will be comfortable financially. But at the rates those plans will be successful, if they are successful, I'll never be rich like you and Mike.”

Rich dad grinned when he heard that. Smiling and laughing quietly to himself, he said, “Investing is not a race. You are not in competition with anyone else. People who compete usually have huge ups and downs in their financial life. You are not here to try to finish first. All you need to do to make more money is simply focus on becoming a better investor. If you focus on improving your experience and education as an investor, you will gain tremendous wealth. If all you want to do is to get rich quickly, or have more money than Mike, then the chances are you will be the big loser . It's OK to compare and compete a little, but the real objective of this process is for you to become a better and more educated investor. Anything other than that is foolish and risky.”

I sat there nodding and feeling a little bit better . I knew then that rather than try to make more money and take bigger risks, I would focus on studying harder.

That made more sense to me, it seemed less risky, and it certainly took less money ... and money was not something I had much of then.

Rich dad went on to explain his reasons for starting Mike out in the I quadrant, rather than the B or E quadrant. He said, “Since the objective of the rich is to have your money work for you so you don't have to work, why not start where you want to wind up.” He went on to explain why he encouraged Mike and me to play golf when we were 10 years old. He said, “Golf is a game you can play all your life. Football is a game you can play for only a few years. So why not start with the game you will end with?”

Of course I had not listened to him. Mike continued playing golf and I went on to baseball, football, and rugby. I was not very good at any of them, but I loved the games and I am glad I played them.

Fifteen years after starting to play golf and beginning to invest, Mike was now a great golfer, had a substantial investment portfolio, and had years more investment experience than I did. At 25, I was just beginning to learn the basics of the game of golf and the game of investing.

I make this point because regardless of how young or old you are, learning the basics of anything, especially a game, is important. Most people take some kind of golf lessons to learn the basics before playing golf , but unfortunately, most people never learn the simple basics of investing before investing their hard-earned money.

“Now that your two plans are in place—the plan for security and the plan for comfort—I will explain the basics of investing,” said rich dad. He went on to explain that too many people begin investing without having the first two plans in place, and that was risky in his mind. He said, “After you have those two plans firmly in place, then you can experiment and learn more exotic techniques utilizing different investment vehicles. That is why I waited for you to take the time to put those two automatic or mechanical investment plans in place before I continued on with your lessons .”

“Investment basic rule number one,” said rich dad, “is to always know what kind of income you are working for. ”

For years, rich dad had always said to Mike and me that there were three different kinds of income:

1. Earned Income: income generally derived from a job or some form of labor . In its most common form, it is income from a paycheck. It is also the highest-taxed income, so it is the hardest income with which to build wealth. When you say to a child, “Get a good job,”

2. Portfolio Income: income generally derived from paper assets such as stocks, bonds, mutual funds, etc. Portfolio income is by far the most popular form of investment income, simply because paper assets are so much easier to manage and maintain than any others. 3. Passive Income: income generally derived from real estate. It can also be income derived from royalties from patents or license agreements. Yet approximately 80% of the time, passive income is from real estate. There are many tax advantages available for real estate.

One of the running battles between my two dads was what a parent should say to a child. My poor dad always said to me, “Work hard at school so you can get good grades. When you get good grades, you will be able to get a good job. Then you become a good hardworking man. ” While Mike and I were in high school, rich dad would snicker at that idea. He used to say, “Your dad is a good hardworking man but he will never get rich if he continues to think that way. If you boys listen to me, you will work hard for portfolio income and passive income if you want to become rich. ”

Back then, I did not fully understand what either man was saying or what the difference in philosophies was all about. At age 25, I was beginning to understand a little better . My dad at age 52 was starting all over again, focused only on earned income, something he had thought was the right thing to do all his life. My rich dad was rich and enjoying life simply because he had lots of all three types of income. I knew now which type of income I was going to work hard for and it was not earned income.

“Investment basic rule number two, ” said rich dad, “is to convert earned income into portfolio income or passive income as efficiently as possible.” Rich dad then drew this diagram on his yellow legal tablet:

“And that, in a nutshell, is all an investor is supposed to do,” rich dad summarized with a smile. “That is about as basic as it can get. ” “But how do I do it?” I asked. “How do I get the money if I don't already have the money? What happens if I lose the money?” I kept asking. “How , how , how ?” said rich dad. “You sound like an Indian Chief from an old movie. ”

“I know they are real questions. But for now, I just want you to understand the basics. Later, I 'll go into the how. OK ? And watch out for the negative thoughts. Look, risk is always part of investing, as it is with life. People who are too negative and avoid risk back themselves out of most opportunities because of their negativity and fear of risk. Got it?”

“Investment basic rule number three, ” said rich dad, nodding to my last statement, “is to keep your earned income secure by purchasing a security you hope converts your earned income into passive income or portfolio income.”

“Secure in a security?” I asked. “I'm confused. What happened to assets and liabilities?”

“Good question,” said rich dad. “I'm now expanding your vocabulary. It is time for you to go beyond the simple understanding of assets and liabilities—an understanding that most people never achieve, I might add. But the point I am making here is that all securities are not necessarily assets, as many people think they are.”

“You mean a stock or piece of real estate is a security, but it may not be an asset?” I asked.

“That is correct. However, many average investors cannot distinguish between a security and an asset. Many people, including many professionals, do not know the difference. Many people call any security an asset.”

“A security is something you hope will keep your money secure. And generally, these securities are bound up tight by government regulations. And that is why the organization that watches over much of the world of investing is called the Securities and Exchange Commission, a.k.a. the SEC. You may notice that its title is not the Assets and Exchange Commission.”

“So the government knows that securities are not necessarily assets, ” I stated. Rich dad nodded and said, “And neither is it called the Securities and

Guarantees Commission. The government knows that all it can do is maintain a tight set of rules and do its best to maintain order by enforcing those rules. It does not guarantee that everyone who acquires a security will make money. That is why securities are not called assets. If you remember the basic definition, an asset puts money in your pocket, or the income column; a liability takes money from your pocket, and that shows up in your expense column. It's simply a matter of basic financial literacy.”

I nodded. “So it is up to the investor to know which securities are assets and which securities are liabilities, ” I stated, beginning to understand where rich dad was going with this.

“That is correct,” said rich dad, again reaching for his legal tablet. He drew this diagram on it:

“The confusion begins for most investors when someone tells them that securities are assets. Average investors are nervous about investing because they know that just because they buy a security, it does not mean they will make money. The problem with buying a security is that the investor can also lose money,” said rich dad.

“So if the security makes money, as your diagram shows, it puts money into the income column of the financial statement, and it is an asset. But if it loses money, and that event is recorded in the expense column of the financial statement, then that security is a liability. In fact, the same security can change from being an asset into a liability. For example, I bought a hundred shares of stock in ABC Company in December for which I paid $20 per share. In January, I sold ten shares for $30 per share. Those ten shares of stock were assets because they generated income for me. But in March, I sold ten more shares for only $10, so that same stock had become a liability because it generated a loss (expense). ”

Rich dad cleared his throat before speaking. “So the way I look at this is that there are instruments called securities in which I invest. It is up to me as the investor to determine if each security is an asset or liability. ”

“And that is where the risk comes in, ” I said. “It is the investor not knowing the difference between an asset or liability that makes investing risky.”

“And why I say investor basic rule number four is, it is the investor that is really the asset or the liability,” said rich dad.

“What?” I asked. “The investor is the asset or liability, not the investment or security?”

Rich dad nodded. “You often hear people say, ‘Investing is risky. ' It's the investor who is risky. It is ultimately the investor who is the asset or the liability. I have seen many so-called investors lose money when everyone else is making money. I have sold businesses to many so-called business people and watch the businesses soon go bust. I have seen people take a perfectly good piece of real estate, real estate that is making a lot of money, and in a few years, that same piece of real estate is running at a loss and falling apart. And then I hear people say, investing is risky. It's the investor who is risky, not the investment. In fact, a good investor loves to follow behind a risky investor because that is where the real investment bargains are found.”

“And that is why you love to listen to investors who are crying the blues about their investment losses, ” I said. “You want to find out what they did wrong and see if you can find a bargain.”

“You've got it,” said rich dad. “I'm always looking for the skipper of the Titanic. ”

“And that is why you don't like to hear stories about people making a lot of money in the stock market or the real estate market. You hate it when someone tells you that he or she bought a stock at $5 and it went to $25.”

“You have observed me well, ” said rich dad. “Listening to tales of quick money and instant wealth is a fool's game. Such stories draw in only the losers. If a stock is well known or has made a lot of money, the party is often already over or soon to be over. I'd rather hear tales of woe and misery because that is where the bargains are. As a person who operates on the B and I side of the quadrant, I want to find securities that are liabilities and turn them into assets, or wait for someone else to begin turning them into assets. ”

“So that would make you a contrarian investor, ” I ventured, “a contrarian being someone who goes against the popular sentiment of the market.” “That is the lay person's idea of what a contrarian investor is. Most people just think a contrarian investor is anti-social and does not like going along with the crowd. But that is not true. As someone who operates on the B and I side of the Quadrant, I like to think of myself as a repairman. I want to look at the wreck and see if it can be fixed. If it can be fixed, then it would still be a good investment only if other investors also want it fixed. If it cannot be fixed or if no one would want it even after it is fixed, I don't want it either . So a true investor must also like what the crowd likes , and that is why I would not say I am a pure contrarian. I will not buy something just because no one else wants it.”

“Yes, there is,” said rich dad. “Investor basic rule number five is that a true investor is prepared for whatever happens. A non-investor tries to predict what and when things will happen.”

“Have you ever heard someone say, ‘I could have bought that land for $500 an acre twenty years ago. And look at it now. Someone built a shopping center right next to it, and now that same land is $500,000 an acre'?”

“We all have,” said rich dad. “Well, that is a case of someone who was not prepared. Most investments that will make you rich are available for only a narrow window of time—a few moments in the world of trading or a window of opportunity that is open for years , as it is in real estate. But regardless of how long the window of opportunity is open, if you are not prepared with education and experience, or extra cash, the opportunity, if it is good, will pass.

“You need to focus and keep in mind what others are already looking for. If you want to buy a stock, then attend classes on how to spot bargains in stocks . The same is true for real estate. It all begins with training your brain to know what to look for and being prepared for the moment the investment is presented to you. It is much like the sport of soccer . You play and play, and then all of a sudden the winning kick at the goal appears. You're either prepared or you're not. You're either in position or you're not. But even if you miss the shot in soccer or in investing, there is always another shot at the goal, or an investment ‘opportunity of a lifetime' right around the corner. The good news is that there are more and more opportunities every day, but first you need to choose your game and learn to play the game.”

“So that is why you chuckle when someone complains about missing out on a good deal or tells you that you must get into this deal or that deal?” “Exactly. Again there are so many people who come from the mindset that there is scarcity, instead of abundance, in the world. They often cry about missing a deal and hang on to a deal too long thinking that it is the only deal, or they buy thinking that what they are looking at is the only deal. If you are good at the ‘B' and ‘I' side of the Quadrant, you have more time and more deals to look at, and your confidence is high because you know you can take a bad deal that most people would reject, and turn it into a good deal. That is what I mean about investing the time to be prepared. If you're prepared, there is a deal of a lifetime being presented to you every day of your life. ”

“And that is how you found that big piece of raw land—just walking down the street,” I commented, recalling how rich dad found one of his best pieces of real estate. “You saw that the ‘For Sale' sign had fallen down and had been trampled on so no one knew the land was for sale. You called the owner and offered him a low but fair price at your terms and he took it. He took your offer because no one else had made him an offer in over two years . That is what you mean, isn't it?”

“Yes, that is what I mean, and that piece of raw land was a better deal than most. That is what I mean about being prepared. I knew what the land was worth and I also knew what was going to happen in that neighborhood in a few months, so there was very low risk coupled with a very low price. I would love to find ten more pieces of land today in that same neighborhood.”

“Well have you ever heard someone say, ‘What if the market crashes? What will happen to my investment then? That is why I am not going to buy. I am going to wait and see what happens'?”

“I have heard many people, when presented with a good investment opportunity, back away from the investment because their core fears begin to predict the disasters that will occur . They sent out their negative vibes and never invest . . . or they sell when they shouldn't sell and they buy something they shouldn't buy based on either optimistic or pessimistic emotional predictions.”

“And that would be handled if they were a little educated, had a little experience, and were prepared, ” I said.

“Exactly,” said rich dad. “Besides, one of the basics of being a good investor is being prepared to profit when the market moves up or if it moves down. In fact, the best investors make more money in a down market move simply because the market falls faster than it rises. As they say, the bull comes up the stairs and the bear goes out the window . If you are not covered for either direction, you as the investor are too risky . . . not the investment. ”

“That means many people predict themselves right out of being rich investors.”

Rich dad nodded. “I have heard so many people say, ‘I don't buy real estate because I don't want calls at midnight to fix toilets. ' Well I don't either . That is why I have property managers. But I do love the tax advantages that cash flow from real estate offers that stocks do not. ”

“So people often predict themselves right out of opportunities , instead of being prepared,” I echoed, beginning to understand why being prepared was so important. “How do I learn to be prepared?”

“I'll teach you some basic trading techniques that all professional investors should know , techniques such as shorts, call options, put options, straddles, etc. But that will come later. Right now , that is enough about the advantages of preparation over prediction for you.”

“But I have one more question about preparation.” “And what is that?” asked rich dad.

“That is investment basic rule number six,” said rich dad. “If you are prepared, which means you have education and experience, and you find a good deal, the money will find you or you will find the money. Good deals seem to bring out the greed in people. And I don't mean to use the world greed in a negative way. I speak of greed as a general human emotion, an emotion we all have. So when a person finds a good deal, the deal attracts the cash. If the deal is bad, then it is really hard to raise the cash. ”

“Many times, but it was not the deal that did not attract the cash. The person controlling the deal did not attract the cash. In other words, the deal would have been good if the guy in charge of the deal had stepped aside. It is like having a world-ranked racecar with an average driver. No matter how good the car is, no one would bet on it with an average driver at the wheel. In real estate, people often say the key to success is location, location, location. I think differently. In reality, in the world of investing—regardless of if it is real estate, business, or paper assets—the key is always people, people, people. I have seen the best real estate in the best location lose money because the wrong people were in charge.”

“So, again, if I am prepared, I have done my homework, I have some experience and a track record, and I find something that is a good investment, then finding the money is not that hard.”

“That has been my experience. Unfortunately, all too often, the worst deals, which are deals that investors like me would not invest in, are presented to unsophisticated investors, and the unsophisticated investors often lose their money.”

“And that is why there is the Securities and Exchange Commission,” I said. “Its job is to protect the average investor from these bad deals. ” “Correct, ” said rich dad. “The primary job of investors is to make sure their money is secure. The next step is to do their best to convert that money into cash flow or capital gains. That is when you find out if you or the person to whom you entrusted your money can turn that security into an asset or if it will become a liability. Again, it is not the investment that is necessarily safe or risky, it is the investor.”

“No. Not by a long shot, ” said rich dad. “Investing is a subject you can learn the basics of for the rest of your life. The good news is that the better you are at the basics, the more money you make and the less risk you have. But there is one more investor basic rule I would like to leave you with. And that is investor basic rule number seven.”

“It is the ability to evaluate risk and reward,” said rich dad. “Give me an example,” I requested.

“Let's say your two basic investment plans are in place. Your nest egg is doing well and you happen to have, let's say, an extra $25,000 you can invest on

“I wish I had $25,000 right now ,” I commented dryly. “But tell me more about evaluating the risk and reward. ”

“So you have this $25,000 that you can more or less afford to lose—which means that if you lost it all, you would cry a little but you could still put food on the table and gas in the car and save another $25,000. Then you begin to evaluate risk and rewards of the more speculative investments.”

“Let's say you have a nephew who has an idea for a hamburger stand. The nephew needs $25,000 to start. Would this be a good investment?” “Emotionally, it could be, but financially it would not be,” I replied. “Why not?” asked rich dad.

“Too much risk and not enough reward,” I replied. “On top of that, how would you get your money back? The most important thing here is not return on investment. The most important thing here is return of investment. As you said, security of capital is very important. ”

“Very good,” said rich dad. “But what if I told you that this nephew has been working for a major burger chain for the past 15 years, has been a vice-president of every important aspect of the business, and is ready to go out on his own and build a worldwide burger chain? And what if for a mere $25,000 you could buy 5% of the entire company? Would that be of interest to you?”

“Yes,” I said. “Definitely, because there is more reward for the same amount of risk. Yet it is still a high-risk deal. ”

“That is correct,” said rich dad. “And that is an example of an investor basic, which is to evaluate risk and reward.”

“Good question,” said rich dad. “That is the rich level of investing, the level of investing that follows the investment plans to be secure and comfortable. You're now talking about acquiring the skills to invest in investments that the rich invest in.”

“So again, it is not the investment that is risky; it is the investor who doesn't have the adequate skills that makes the investment even higher risk.”

“Correct, ” said rich dad. “At this level, the level at which the rich invest in, the investor should have the three Es. And the three Es are:

investments of the rich takes excessive cash, which means you can truly afford to lose and still profit from the loss. ”

“We will get into that,” said rich dad. “In the rich level of investing, you will find out that things are different. At the rich level, you will find out that there are good losses and bad losses. Good debt and bad debt. Good expenses and bad expenses. At the rich level, your educational requirements and experience will need to go up dramatically. If not, you will not be there for long. Got it?”

Rich dad went on to explain that if things do not follow the KISS (keep it simple, silly) formula, then the risk is probably high. He said, “If someone cannot explain the investment to you in less than two minutes, and you understand it, then either you don't understand, he doesn't understand, or you both don't understand. Whatever the case, it is best that you pass on the investment. ”

He also said, “All too often, people try to make investing sound complex, so they use intelligent-sounding jargon. If someone does that, ask him or her to use simple English. If he or she can't explain the investment so a 10-year-old can understand at least the overall concept, chances are he or she does not understand it either. After all, all p/e means is how expensive the stock is. And a cap rate, which is a term used in real estate, just measures how much money the property puts or does not put in your pocket.”

“No, I'm not saying that either, ” said rich dad. “All too often, people who lack interest in investing or have a loser 's attitude will say, ‘Man if it's not easy, I won't do it.' I often say to that type of person, ‘Well when you were born, your parents had to work hard and potty train you. So even going to the toilet was at one time difficult. Today, hopefully, you are potty trained, and going to the potty by yourself is just part of the basics. '”

I have found that too many people want to invest in the investments of the rich without first having a strong financial foundation under them. All too often, people want to invest at the rich person's level because they are hurting financially and often need money desperately. Obviously, I do not recommend investments at a rich person's level unless you are already rich. Neither did my rich dad.

Some people are fortunate enough that their financial plan to be “comfortable” creates enough excess cash to make them think they are rich. But unless they learn to think as rich people think, they will still be poor people. They will be just be poor people with money.

1. If you are going to invest, or intend to invest, in what the rich invest in, are you willing to gain what rich dad called the 3-E's ? They are:

If the answer is no, then the remainder of this book may not be of much value, nor could I in good conscience recommend any of the investments I will be writing about, which are the investments of the rich.

If you are uncertain or are curious about some of the requirements involved in the education and experience that can lead to acquiring excessive cash, then read on. At the end of this book, you can decide whether or not you want to go after the 3-Es, if you do not already have them.

Along the way, you may discover that your plans to be financially safe, and then financially comfortable, will allow you to “raise the bar.” Just as a high jumper or pole-vaulter raises the bar after succeeding at each level, you can succeed financially at the safety and comfort levels. You can then “raise the bar” — and your goals—and focus more of your time on becoming rich.

As rich dad said, “Investing is a subject where you can study the basics for the rest of your life. ” What he meant was that it sounds complex at the start and then it gets simple. The more simple you can make this subject, or the more basics you learn, the richer you can become while reducing risk. But the challenge for most people is to invest the time.