How A Sophisticated Investor Thinks

“Now that you understand the B-I Triangle, are you ready to build a business?” rich dad asked me.

“Yes, absolutely. Even though it is a little intimidating,” I replied. “There is so much to remember.”

“That's the point, Robert. Once you build a successful business, you will have the skills to build as many as you want. You will also have the skills to analyze other businesses from the outside before you invest in them.”

“Maybe it is because you're thinking of building huge businesses, ” rich dad continued.

“To learn the skills needed for the B-I Triangle, you need to start small. Even a hot dog cart or a small rental home needs its own B-I Triangle. Every component of the B-I Triangle applies to even the smallest business. You will make mistakes. If you learn from those mistakes, you can build bigger and bigger businesses. In the process, you will become a sophisticated investor.”

“So learning to build a business will make me a sophisticated investor?” I asked. “Is that all it takes?”

“If you learn the lessons along the way and build a successful business, you can become a sophisticated investor,” rich dad continued, as he brought out his infamous yellow pad. “It's making the first million dollars that's difficult. After you've made the first million, the next ten million are easy. Let's discuss what makes a successful businessperson and investor a sophisticated investor.”

“A sophisticated investor is an investor who understands each of the ten investor controls. The sophisticated investor understands and benefits from the advantages of the right side of the Quadrant. Let's go through each investor control so you get a better understanding of how a sophisticated investor thinks, ” rich dad explained.

“It is important to understand that a sophisticated investor may choose not to become an inside investor or ultimate investor; rather, he or she understands the benefits of each control,” rich dad continued. “The more controls these investors possess, the less risk they have in the investment.”

“The most important control you must have as an investor is control over yourself.” It can determine your success as an investor and is why the entire first phase of the book is dedicated to getting control over yourself. Rich dad often also said, “It isn't the investment that is risky, it is the investor who is risky!”

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. 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 , that the best learning comes through making mistakes, and that financial literacy is essential to be successful. They know their own financial statement, and they understand how each financial decision they make will ultimately impact their financial statement.

This control is developed through financial literacy. My rich dad taught me the three cash flow patterns of the poor, middle class, and the rich. I decided at an early age that I wanted to have the cash flow pattern of a rich person.

The poor spend every penny they make—they have no assets and no debt. The cash flow pattern of the middle class:

Individuals in the middle class accumulate more debt as they become more successful. A pay raise qualifies them to borrow more money from the bank so they can buy personal items like bigger cars, vacation homes, boats, and motor homes. Their wage income comes in and is spent on current expenses and then on paying off this personal debt.

As their income increases, so does their personal debt. This is what we call the “Rat Race. ”

The rich have their assets 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 few, if any, personal liabilities.

You may have a cash flow pattern that is a combination of these three types. What story does your financial statement tell? Are you in control of your expenses?

Sophisticated investors buy assets that put money in their pockets. It is just that simple.

Sophisticated investors understand that businesses are allowed to deduct all the ordinary and necessary expenses paid or incurred for the business. They analyze their expenses and convert non-deductible personal expenses into deductible business expenses whenever possible. Not every expense will be an allowable deduction.

Review your business and personal expenses with your financial and tax advisors so that you can maximize the deductions available to you through your business. Some examples of personal expenses that could be legitimate business expenses are:

Home costs Home office Follow guidelines—track all home expenses and reimburse based on square footage

These are just a few examples of the types of business expenses that are deductible expenses for business owners. The same expenses are not usually deductible for employees. Your expenses must be properly documented and have a legitimate business purpose. Can you think of expenses you are paying personally today that could be deductible business expenses if you owned a business?

An inside investor who owns enough of an interest in the investment whereby he or she can control the management decisions has this investor control. It can be as a sole owner or where the investor owns 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 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.

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, which the sophisticated investor uses thoughtfully to minimize his or her taxes paid as well as to increase tax deferrals wherever possible.

In the United States, those on the right side of the Quadrant enjoy many tax advantages that are not available to those on the left side. Three specific advantages are:

s1. (Social Security in the United States, “Social insurance” taxes Medicare tax, unemployment tax, and disability income, to name just a few) do NOT apply to passive and portfolio income (right side of the Cashflow Quadrant) but do apply to earned income (left side of the Cashflow Quadrant).

2. It may be possible to defer payment of taxes, perhaps indefinitely, by using the laws available to you related to real estate and owning a company (an example would be a profit-sharing plan sponsored by your business corporation).

3. C Corporations may pay for a number of expenditures with pre-tax dollars that E income recipients must pay for with after-tax dollars. Some examples are included under Investor Control #2.

Sophisticated investors recognize that each country, state, and province has difference tax laws, and they are prepared to move their business affairs to the place best suited for what they are doing.

Recognizing that taxes are the largest expense in the E and S quadrants, sophisticated investors may well seek to reduce their income in order to reduce income taxes while increasing funds for investment simultaneously. See the example under Investor Control #7.

The sophisticated investor knows how to make money in an up market as well as in a down market.

In building a business, the sophisticated investor has great patience. I sometimes refer to this patience 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.

The sophisticated investor operating as an inside investor can direct how the investment is sold or expanded.

As an outside investor in other companies, the sophisticated investor carefully tracks the performance of his or her investments and directs his or her broker to buy or sell.

Many investors today rely on their brokers to know when to buy and sell. These investors are not sophisticated.

“Next to control over yourself , the control over the E-T-C is the most important control, ” rich dad would repeat often. 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 earned income into passive and portfolio income as possible. This, combined with the ability to read financial statements and “think in terms of financial statements,” helped rich dad build his financial empire more quickly.

To illustrate what proper E-T-C planning can do, let's review the following case studies about James and Cathy.

James and Cathy are the absentee owners of a restaurant. The restaurant is operated as a sole proprietorship. They have two children.

Their net income from the restaurant is $60,000. James and Cathy have one financial statement.

James and Cathy met with their financial and tax advisors to structure their businesses to maximize their cash flow and minimize the amount they must pay in taxes.

James and Cathy own two corporations; one owns the restaurant, and the other owns the building where the restaurant is located.

James is the general manager for both corporations. James and Cathy have two children.

James and Cathy have three sets of financial statements that impact their financial position.

How Did James and Cathy Benefit from the Advice of Their Financial and Tax Advisors?

1. James and Cathy can convert certain personal expenses into legitimate business expenses (health insurance, legal and accounting expenses, education expenses, and a home office and auto deduction) .

5. They have protected their personal assets by putting their business operations into corporations, one owned 100% by James and the other owned 100% by Cathy.

Let's see how they were able to accomplish all of this: James and Cathy's Financial Statement

Flow The end result of this financial plan for James and Cathy is that they have

added $7,885 to their personal wealth by saving $7,885 in taxes. More importantly, however , they have protected their personal assets by moving their businesses into corporations. By having validly established corporations, their personal assets should be safe even if a judgment is awarded against one of the corporations. For instance, if a customer becomes ill in the restaurant, he or she can sue the corporation that owns the restaurant. Any judgment against the restaurant corporation would be paid out of the assets of that corporation. The corporation that owns the building, and the personal assets of James and Cathy, should be protected.

James and Cathy's example is very simplified and provided for illustration purposes only. It is extremely important that you seek professional legal and tax advice before structuring your own financial plan. You must consider many complex issues to ensure you comply with all laws.

All of these numbers look very complicated to me so I have also included the simple diagram rich dad showed me when he described his restaurant and real estate corporations. I learn better with pictures than numbers, so maybe it will help you too.

statements, you can then operate multiple businesses as well as evaluate other investments quickly. However, most importantly, once you can think in financial statements, you will gain even greater control over your financial life and make even more money, money that the average person doesn't realize can be made. ”

I looked at the diagram and said, “Your expenses go to what you have control of. In this case, your restaurant business pays its rent to your real estate investment company.”

“You are taking earned income from your restaurant business and converting it into passive income for your real estate company. In other words, you are paying yourself.”

“And that is just the beginning,” said rich dad. “Yet, I want to caution you that from here on in, you will need the best accounting and legal advice possible. This is where unsophisticated investors begin to get into trouble. They get into trouble because the diagram I showed you can be done legally and it can be done illegally. There must always be a business purpose for the transactions between the corporations, and certain control group ownership issues must be considered when you own stock in multiple corporations. It is too easy to make money legally, so hire the best advisors, and you will learn even more about how the rich get richer, legally.

The sophisticated investor is in control over the terms and conditions of agreements when he or she is on the inside of the investment. For instance, when I rolled over the sale of several of my small houses into a small apartment building, I used a Section 1031 exchange (U.S. law), which allowed me to roll over the gain. I did not have to pay any taxes on the sale because I controlled the terms and conditions of the agreements.

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).

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