Investor Lesson 13 - Reduce Risk Through Financial Literacy

It was still early in the spring of 1974. I had but a couple of months to go before I was discharged from my military contract. I still did not know what I was going to do once I drove off the base for the last time. President Nixon was in trouble with Watergate and the trials were about to begin, so I realized that he had larger concerns than I did at that moment. We all knew the war in Vietnam was over and we had lost. I still had a very short military haircut and I stood out each time I went into the civilian world, where long hippie hair was the style. I began to wonder what I would look like in shoulder-length hair . I had worn a military hair cut since 1965, ever since I entered the military academy for college. It was the wrong period of time to have short hair.

The stock market had been going down for the past four days and people were nervous. Even in the pilots' ready room on base, the few pilots that did play the market were nervous and edgy. One had sold all his stock to stand aside with cash. I was not invested in the stock market at the time, so I could watch the effect of the ups and downs of the market had on people without emotion.

Rich dad and I met for lunch at his favorite beachside hotel. He was happy as ever . The market was falling and he was making even more money. I thought it strange that he would be calm and happy and everyone else, even the commentator on the radio, was nervous.

“How is it that you are happy and everyone else I meet who is in the stock market is nervous?”

“Well, we talked about it earlier ,” said rich dad. “We talked about one of the basics of being an investor is to be prepared for whatever happens, rather than attempt to predict what is about to happen. I doubt if anyone can predict the market, although there are many people who claim they can. A person can predict something happening maybe once, maybe even twice, but I have never seen anyone predict anything regarding the market, three times in a row. If there is such a person, he or she must have a high-powered crystal ball.”

“Most people I talk to believe that investing is risky, so they keep their money in the bank, in money market funds or CDs.”

“As they should, ” said rich dad, pausing for a moment and then continuing. “For most people, investing is risky, but always remember that it is not necessarily investing that is risky, it is the investor who is risky. Many people who think they are investors are not really investors. In reality, they are speculators, traders, or—even worse—gamblers. There are fine lines of distinction between those characters and a true investor . Don't get me wrong, there are speculators, traders, and gamblers who do very well financially. But they are not what I would categorize as investors.”

“Good question,” said rich dad. “Or maybe a better question might be, how do I become an investor who makes a lot of money with very little risk? And then hang on to the money I make?”

“My answer is the same. It is to keep things simple and understand the basics. Begin with having your investment plans for security and comfort in place. Those plans are often handled by someone else you hope is competent and following an automatic no-brainer formula. Then you have to pay the price to become an investor who wants to make more money with less risk.”

“Time,” said rich dad. “Time is your most important asset. If you are not willing to invest your time, then leave your investment capital with people who are following the investment plan of your choice. Many people dream of getting rich but most will not pay the price of the investment of their time.”

I could tell that rich dad was still very much into the mental preparation mode of our lessons. But by now , I was ready to go. I really wanted to learn to invest following his investment formula. Yet he was still testing my determination to invest my time and effort to learn what I needed to learn. I therefore raised my voice so the tables around me could hear and said, “I want to learn. I am willing to invest my time. I will study. I won't quit on you. You are not wasting your time teaching me. Just tell me what the basics are to becoming a successful investor with very low risk.”

“Good, ” said rich dad. “I've been waiting for some fire. I got concerned this morning when you came in concerned about the market going down. If you let the ups and downs of the stock market run your life, you should not be an investor. The number one control you must have to be an investor is control over yourself. If you cannot control yourself , the highs and lows of the market will run you and you will lose during one of those ups or downs. The number one reason people are not good investors is that they lack control over themselves and their emotions. Their desire for security and comfort takes control of their heart, their soul, their mind, their view of the world, and their actions. As I said, a true investor does not care which direction the market goes. A true investor will make money in either direction. So ‘control over yourself ' is the first and most important control. Got it?”

“I got it,” I said as I backed up in my chair a little. I had come in a little wimpy and concerned. Yet I had been studying with rich dad for years and I knew that his intensity was letting me know that the lessons on investing were just about to begin.

Rich dad continued at a rapid-fire pace. “So if you want to invest with very low risk and high returns, you have to pay the price. And the price involves study, lots of study. You need to study the basics of business. So to be a rich investor, you also have to either be a good business owner, or know what a business owner knows. In the stock market, investors want to invest in successful Bs. If you possess the skills of a B, you can either create your own business as a B or analyze other businesses as potential investments as an I . The problem is, most people are trained to be Es or Ss in school. They do not have the skills needed by a B. That is why so few people become very rich investors. ”

“Exactly,” said rich dad as he reached for his legal tablet. “This is what

fundamental investing is. This is a simple diagram of the basic formula I follow as well as many ultra-rich investors. ”

“In the world of investing, there are three basic asset classes you can invest in. We already covered the idea of earned income, passive income, and portfolio income. Well, the big difference between the really rich and the average rich is the tetrahedron I drew here.”

“Probably the best investment of all, if you want to become a rich investor. Roughly 80% of the very rich became rich through building a business . Most people work for people who build businesses or invest in businesses. Then they wonder why the person who built the business is so rich. The reason is that the builder of a business will always trade money for the asset.”

“You mean the builder or owner of the business values the asset more than the money?” I asked.

“That is part of the picture because all an investor really does is trade time, expertise, or money for a security that they hope or intend will become an asset. So just as you trade money to buy an investment piece of real estate, like a rental house, or pay money for a share or stock, a business owner will pay people money to build a business asset. One of the main reasons the poor and middle class struggle is that they value money over true assets. ”

“So the poor and the middle class value money and the rich don't really value it. Is that what you're saying?”

“Gresham's Law?” I replied. “I've never heard of Gresham's Law. What is that?”

“Gresham's Law is an economic law that states that bad money will always drive out good money.”

“Let me explain,” said rich dad. “Gresham's Law has been in effect since humans began valuing money. Back in Roman times, people used to clip silver and gold coins. Clipping coins meant that people would shave a little bit off the coin before handing it to someone else. So the coin began to lose value. The Roman people were not stupid and soon noticed that the coins were lighter. Once the Roman people knew what was happening, they hoarded the coins with high silver and gold content and spent only the lighter coins. That is an example of bad money driving good money out of circulation.

“To combat this clipping of coins, the government began reeding coins, which is why coins of value have the tiny grooves on the edge. If a coin had the groves filed down, a person knew the coin had been tampered with. Ironically, it is the government that does the most clipping of the value of our money.”

“But that was back in Roman times. How does that law apply today?” I asked. “In 1965, less than ten years ago, Gresham's Law began working in the United States when the government stopped producing coins with silver in them. In other words, the government began producing bad coins, or coins without any real value to them. Immediately, people began hoarding the real silver coins and spending the debased or fake coins.”

“In other words, people somehow intuitively know that government money is not worth much,” I stated.

“It seems that way,” said rich dad, “which may be why I think people save less and spend more. Unfortunately, the poor and middle class buy things that have even less value than their money. They turn cash into trash. Meanwhile, the rich buy things like businesses, stocks, and real estate with their money. They are looking for secure securities in a time when money has an ever-decreasing real value. That is why I've constantly said to you and Mike, ‘The rich do not work for money.' If you want to be rich, you have to know the difference between good money and bad money…assets and liabilities. ”

Rich dad nodded. “That is why I have always said to you, ‘The rich don't work for money. ' I say that because the rich are smart enough to know that money is worth less and less. If you work hard for bad money and do not know the difference between assets and liabilities, good securities , and bad securities, you may struggle financially all your life. It is truly a shame that those who work the hardest and are paid the least suffer the most from this constant erosion of money's value. People who do the hardest work have the hardest time getting ahead due to the effects of Gresham's Law . Since money has ever-declining value, a financially wise person must constantly seek things that do have value and can also produce more and more debased money. If you don't do that, you fall behind financially over time rather than get ahead.”

“I am more secure today than your dad because I worked hard to acquire all three of these basic assets or securities. Your dad has chosen to work hard for job security. So what he has worked hard for looks like this:”

“So when he lost his job, he found out that he had worked hard for nothing. And worst of all, he was successful. He worked himself all the way to the top of the state education system but then he bucked the system. There goes his job security with the state government. I feel for your dad almost as much as you do. But you cannot talk to someone who has very set core values and is not willing to change. He is out looking for another job rather than asking himself if a job will get him what he really wants.”

“So he clung to job security and false assets. However, he failed to convert his earned income into real assets so he could have a rich person's income, which is passive income or portfolio income, ” I said. “He should have done that, converting his paycheck into real securities, before taking on the system.”

“Your dad is a brave man, highly educated, but not financially well educated. And that was his downfall. If he were rich, he could influence the system with campaign contributions, but since he had no money, all he could do was protest and defy the government. Protest is effective, but it takes a heck of a lot of people protesting to make any change in government. Just look at how many protesting people it is taking to stop this Vietnam War.”

“The irony is that he was protesting against the power of the rich to influence government by campaign contributions,” I said. “He saw the power that people with money had over politicians and the favors the rich receive or the laws that were passed in favor of the rich. My dad saw the money involved in politics and so he ran for lieutenant governor to try and stop that financial abuse. Now it has cost him his position in the government. He knows the laws are written in favor of the rich.”

“Well, that is another subject on money. But not our subject today,” said rich dad.

“I've already made up my mind, ” I said. “I have not followed up on any of the jobs for pilots. I will soon begin looking for a job with a company that has sales training, so I can overcome my fear of rejection and learn to sell, or communicate, as you recommended. ”

“Good, ” said rich dad. “Both IBM and Xerox have excellent sales training programs. If you're going to be in the B quadrant, then you must know how to sell as well as market. You also have to have a very thick skin and not mind people saying ‘No' to you. But you also have to be able to change their mind if it is appropriate to do so. Selling is a very necessary, basic skill for anyone who wants to become rich, especially in the B quadrant and very often in the I quadrant.”

“How can you say investing is not risky when most people say investing is risky?”

“Easy,” said rich dad. “I can read financial statements and most people cannot. Do you remember me saying to you years ago that your dad was word literate but not financially literate?”

“Financial literacy is one of the most important investor basics, especially if you want to be a safe investor , an inside investor, and a rich investor. Anyone who is not financially literate cannot see into an investment. Just as a doctor uses X-rays to look at your skeletal system, a financial statement allows you to look into an investment and see the truth, the facts, the fiction, the opportunities, and the risk. Reading a financial statement of a business or individual is like reading a biography or an autobiography.”

“So one of the reasons many people say investing is risky is simply that they have never been taught to read financial statements?” I asked in surprise. “And that is why you began by teaching Mike and me to read financial statements starting when we were nine?”

“Well, if you remember, you told me when you were just 9 years old that you wanted to be rich. When you told me that, I began with the basics: never work for money, learn to spot opportunities not jobs, and learn to read financial statements. Most people leave school looking for jobs, not opportunities; they have been taught to work hard for earned income rather than passive income or portfolio income; and most have never been taught how to balance a checkbook, much less read and write a financial statement. Small wonder they say investing is risky.”

“A business has a financial statement, a stock certificate is a reflection of a financial statement, each piece of real estate has a financial statement, and each of us as an individual human being has a financial statement attached to us, ” said rich dad.

“Every security and human being?” I asked. “Even my dad? Even my mom?” “Sure,” said rich dad. “Everything—regardless of if it is a business, real estate, or human being—that transacts money has an income statement and balance sheet, whether or not they know it. People who are not aware of the power of a financial statement often have the least money and the biggest financial problems.” “You mean like my dad is having right now ,” I said.

“Unfortunately that is true,” said rich dad. “Not knowing the simple difference between assets and liabilities, earned income from passive and portfolio income, and not knowing where they all appear and how they flow on a financial statement has been a costly oversight for your dad.”

“So when you look at a business, you look at the financial statement, not the price of its stock that day?” I asked, doing my best to move the discussion away from my dad.

Financial literacy is fundamental to fundamental investing. When I look at the financials of a business, I look at the guts of a business. When I look at the financials, I can tell if the business is fundamentally strong or weak, growing or declining. I can tell if the management is doing a good job or wasting a lot of the investors' money. The same is true with an apartment building or office building. ”

“So by reading the financials, you can tell for yourself if the investment is risky or safe,” I added.

“Yes,” said rich dad. A person's, a business's, or a piece of real estate's financials will tell me much more than that. But a cursory look at a financial does three more important things .”

“For one thing, being financially literate gives me a checklist of what is important. I can look at each line and determine what is not being done right, or what I can do to improve the business and make things right. Most investors look at the price and then the stock's p/e, or price earnings ratio. The p/e of a stock is an outsider 's indicator of the business. An insider needs other indicators, and that is what I will teach you. Those indicators are part of a safety checklist to make sure all the parts of the business are functioning well. If you are not financially literate, you cannot tell the differences. Then, of course, investing is risky for that person.”

“The second thing is when I look at an investment, I also overlay it on my personal financial statement, and see where it fits. As I said, investing is a plan. I want to see how the business, the stock, mutual fund, bond, or real estate's financial statement impacts my personal financial statement. I want to know that this investment will get me to where I want to go. I can also analyze how I can afford the investment. By knowing my numbers, I know what will happen if I borrow money to buy an investment and the long-term impact balanced with income and outflow due to debt payments. ”

“I want to know that this investment is safe and will make me money. I can tell if it is going to make money or lose money in a very short period of time. So if it does not make me money, or I cannot fix the reason why it will not make me money, why should I buy it? That would be risky.”

“In most instances,” said rich dad. “Yet as simple as that sounds, it always amazes me when I meet people who are losing money or making no money and they think they are investors. Many people who invest in real estate lose money every month and then say, ‘But the government gives me a tax break for my losses. ' That is like saying, ‘If you lose a dollar, the government will give you 30 cents back. ' A few very sophisticated business people and investors know how to use that government ploy to their advantage, but very few people really do. Why not make a dollar and get an additional 30 cent bonus from the government? That is what a real investor does.”

“People actually do that? They actually lose money and think it is investing?” “On top of that, they think losing money for tax advantages is a good idea. Do you know how easy it is to find an investment that loses money?” asked rich dad. “I imagine it would be pretty easy, ” I said. “The world is filled with stocks, mutual funds, real estate, and businesses that do not make any money.”

“So a real investor first wants to make money, and then after making money, they want an additional bonus from the government. So a real investor will make a dollar as well as get a 30 cent bonus from the government. An unsophisticated investor will lose a dollar and be thrilled to get 30 cents from the government in the form of a tax write-off .”

“That is one of the basics . Financial literacy is definitely an important investor basic at the rich investment level. The other basic is to invest to make money. Never invest with the intent to lose money and then be happy with a tax write-off. You invest for one reason only: to make money. Investing is risky enough without investing to lose money.”

As we ended the lesson for the day, rich dad said, “Now do you realize why I had you do your personal financial statements so often?”

I nodded and said, “As well as analyze the financial statements of businesses and real estate investments. You kept saying you wanted me to think in financial statements. Now I understand why. ”

“While you were in school, you got a report card once a quarter . A financial statement is your report card once you leave school. The problem is that since most people have not been trained to read financial statements or how to keep a personal financial statement, they have no idea how they are doing once they leave school. Many people have failing marks on their personal financial statements but think they are doing well because they have a high-paying job and a nice home. Unfortunately, if I were handing out the grades, anyone who was not financially independent by age 45 would receive a failing grade. It is not that I want to be cruel. I just want people to wake up and maybe do a few things differently . . . before they run out of their most important asset: time. ”

“So you reduce risk by being able to read financial statements,” I replied. “A person needs to get his or her own personal financial statement under control before investing.”

“Definitely,” said rich dad. “This whole process I have been talking to you about is the process of taking control of yourself , which also means your financial statement. So many people want to invest because they are deep in debt. Investing in the hopes of making more money so you can pay bills or buy a bigger house or a new car is a fool's investment plan. You invest for one reason: to acquire an asset that converts earned income into passive income or portfolio income. That conversion of one form of income into another form of income is the primary objective of a true investor. And to do that requires a higher degree of financial literacy than simply balancing a checkbook.”

“So you're not concerned about the price of a stock or piece of real estate. You're more concerned with the operating fundamentals, the fundamentals that you can see with a financial statement?”

“Right,” said rich dad. “That is why I got upset with your being concerned about the prices on the stock market. While price is important, it is far from the most important thing in fundamental investing. Price is more relevant in technical investing, but technical investing is another lesson. Now do you understand why I had you do so many personal financial statements and analyze businesses and real estate investments?”

I nodded. “I hated it at the time, but now I'm glad you had me do so many of them. I realize now how much I think and analyze things using mental photos of my financial statement and how what I do with my money affects my financial statement. I did not realize that most people do not think with the same photo references.”

“You are far ahead of the game, ” said rich dad, “the game of getting rich. I have a term for the income statement and the balance sheet, the two primary reports that make up financial statements: the magic carpet.”

“Because they seem to magically take you behind the scenes into any business, any piece of real estate, and any country in the world. It is much like taking a diving mask and suddenly looking below the surface of the water . The mask, symbolizing the financial statement, lets you see clearly what is going on beneath the surface. Alternatively, a financial statement is like having Superman's X -ray vision. Instead of trying to jump over the tall building, a financially literate person can see right through the building's concrete walls. Another reason I call them the magic carpet is because they free you to see and do so many things in so many parts of the world, all the while sitting at your desk. You can invest in so many parts of the world or just in your backyard with so much more knowledge and insight. Improving my financial literacy ultimately reduces my risk and improves my investment returns. A financial statement lets me see what the average investor cannot see. It also gives me control over my personal finances, and that allows me to go where I want to go in my life. Having control over financial statements also allows me to operate multiple businesses without being in the business physically. Truly understanding financial statements is one of the keys still necessary for an S quadrant person to move to the B quadrant. And that is why I call the income statement and balance sheet the magic carpet.”

If we were going to buy a used car, we would probably want a mechanic to look it over and hook it up to an electronic analyzer before deciding if it was worth the asking price asked. If we were going to buy a house, we would ask a home inspector to go through a checklist and check out such things as the condition of the foundation, plumbing, electricity, roof, etc., before buying the house. If we were going to marry someone, we would probably want to know what was really going on beneath the pretty face before deciding to spend a lifetime with that pretty face.

Yet, when it comes to investing, most investors never read the financial statements of the company they are investing in. Most investors would rather invest on a hot tip or a low price or high price, depending upon the momentum of the market. Most people get their cars tuned up and check out annually, or have an annual health physical, but most people have never had their financial statements analyzed for flaws or potential future problems. The reason is that most people leave school unaware of the importance of a financial statement, much less how to control one. Small wonder why so many people say investing is risky. Investing is not risky. But not being financially literate is.

If you have plans on becoming rich by being an investor, I would say that having a good working knowledge of a financial statement is a minimum requirement. Not only will it improve your safety factor, it will also allow you to make much more money in a shorter period of time. The reason I say this is because being able to read a financial statement will allow you to see investment opportunities that the average investor misses. The average investor looks primarily to price as the opportunity to buy or sell. The sophisticated investor has trained his or her brain to see opportunities other than price. The sophisticated investor knows that most of the best investment opportunities are not visible to the untrained eye.

Rich dad taught me that you make the most money as an investor by being financially literate as well as knowing internal strengths and weaknesses of the investment. He said, “Where you find the best investment opportunities is from understanding accounting, the tax code, business law, and corporate law. And it is in these invisible realms where the real investors shop for the biggest investment bargains. That is why I call the income statement and balance sheet the magic carpet. ”

1. If you plan to become wealthy as an investor and invest in the investments of the rich, are you willing to keep an updated personal financial statement and practice reading other financial statements on a regular basis?