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The Difference Between an Average and a Sophisticated Investor

Over the last few weeks, I’ve been talking a lot about average and sophisticated investors. If I could give one summary, it would be this: The average investor views risk from a completely different point of view than the sophisticated investor. And it is this view of risk that truly differentiates the sophisticated investor.

As my rich dad said, “If you want to become really rich, then one of the things you’ll have to change is your point of view on what you think is risky and what is secure. What the poor and the middle class think is secure, I think is risky.”

The following is a handy chart I created to contrast the difference between an average investor and sophisticated investor’s view of risk. It could be helpful to study it and honestly assess which views are yours today…and which you’d like to work towards adopting.

Average InvestorSophisticated Investor
Only one financial statement.Multiple financial statements.
Wants everything in their name.Wants nothing in their name. Uses corporate entities. Often personal residence and automobile are not in their names.
Does not think of insurance as an investment. Uses words such as “diversity.”Uses insurance as an investment product to hedge against exposed risk. Uses words like “covered,” “exposure,” and “hedge.”
Holds only paper assets, which include cash and savingsHas both paper assets and hard assets, such as real estate and precious metals. Precious metals are a hedge against government mismanagement of the money supply.
Focuses on job security.Focuses on financial freedom.
Focuses on professional education. Avoids making mistakes.Focuses on financial education. Understands that mistakes are part of learning.
Does not often seek financial information and wants it free if sought.Willing to pay for financial information.
Thinks in terms of good or bad, black or white, right or wrong.Thinks in financial gray.
Looks at past indicators, such as P/Es and capitalization rates.Looks for future indicators—such as trends, pro formas, and changes in management and products.
Calls brokers first and asks for investment advice. Or invests alone, asking no one for advice.Calls broker last, after consulting with plan and team of financial advisors. (Brokers are often part of the team.)
Seeks external security, such as a job, company, or government.Values personal self-confidence and independence.

Understanding the law and making it work for you

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.

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.”

Start being more sophisticated today!

If you want to move from being average to sophisticated when it comes to your investments, you have to start with an investment in your financial education—and you have to start today.

If you want to learn more about what the rich think about risk—and why they think that way—IGrow Wealth Investments offers a wealth of classes that range from beginning to advanced, sophisticated investing.

Source: http://www.richdad.com/Resources/Rich-Dad-Financial-Education-Blog/November-2014/the-difference-between-average-and-sophisticated.aspx

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