Live Your Financial Life With Less Risk
Many ﬁnancial advisors will tell you that higher returns mean higher risk. In other words, leverage is risky. That is absolutely false. Leverage is risky only when people invest in assets that they have no control over. If a person has control, leverage can be applied with very little risk. The reason most ﬁnancial advisors say that higher returns mean the higher risk is simply because they sell only investments that allow very little control.
For example, Kim and I purchased a 300-unit apartment building in Tulsa, Oklahoma and because I have control, I am conﬁdent about using a lot more leverage. Due to control and leverage, I can achieve greater wealth, in less time, with very little risk, and minimize the eﬀect of the booms and busts of markets on my investments.
Assets such as a business or real estate require more ﬁnancial intelligence, allow for more ﬁnancial control, and permit a higher degree of leverage with very low risk. The key to low risk is higher ﬁnancial intelligence. This is why I recommend that people start small and stay small, as they allow their ﬁnancial intelligence to increase. With an increase in ﬁnancial intelligence, their returns on their investments increase.
In very simple terms, the deﬁnition of leverage is doing more with less. A person who puts money in the bank, for example, has no leverage. It’s the person’s money. A dollar in savings has a leverage factor of 1:1. The saver puts up all the money.
For my investment in the 300-unit apartment house, my banker put up 80 percent of the $17 million real estate investment. By using my banker’s money, my leverage is 1:4. For every dollar I invest in the deal, the bank lends me four dollars.
While savings and a diversiﬁed mutual fund portfolio are a form of leverage, there are better ways to leverage your money. If a person is truthful, he or she has to admit it doesn’t require much ﬁnancial intelligence to save money and invest in mutual funds. You can train a monkey to save money and invest in mutual funds. That is why the returns on those investment vehicles are historically low.
As I said earlier, many people think that higher returns on investment require higher degrees of risk. That is not true. I achieve exceptional returns, and pay very little, if anything, in taxes, all with very low risk. To me, having a well-diversiﬁed mutual fund portfolio and savings in the bank is a lot riskier than what I do. It is all a matter of ﬁnancial intelligence.
Higher Returns with Less Risk
I’m going to further explain why I am willing to use a lot of leverage, why I believe the risk is low, how I make more money, and how I pay less in taxes. There are three more advanced investment strategies, investment strategies that require a higher level of ﬁnancial intelligence.
The three advanced leverage strategies are OPM, ROI, and IRR.
- OPM: Other people’s money. There are many ways to use OPM. With my 300-unit apartment building, I am using 80 percent leverage. First of all, the beauty of using the bank’s money is that it is tax-free money.
- ROI: Return on investment. A confusing concept for many investors is the return on their money, or ROI. For example, when you read ﬁnancial publications, many mutual funds claim they have gone up by 10 percent. But my question is, did any of that 10 percent return to the investor? And how did they measure that 10 percent? Some funds measure the 10 percent by the price of the shares in the fund going up. For example, if a year ago the price per share in the fund was $10 and today it’s $11, they can claim a 10 percent return. In this case, the return was measured in capital gains.
- IRR: Internal rate of return. One of the more complex, sophisticated, and often confusing measures of ROI is the internal rate of return. If investors really know what they are doing, they can increase their ROI by understanding IRR.
As an investor who invests for both capital gains and cash ﬂow, the only return I count is the cash ﬂow. For example, if I invest $10 and each year after taxes I put $1 in my pocket from cash ﬂow, my return is 10 percent. I do not count the return on asset appreciation because it is an estimate and does not become a reality unless I sell the asset.
The diﬀerence is that one measure of the ROI is in the price of the stock, and the other measure of ROI is money in my pocket. I actually want both, 10 percent in asset appreciation and 10 percent cash in my pocket. But cash ﬂow is the only return that can be tangibly measured while I hold the asset.
The reason leverage is so important is that the higher the leverage, the higher the return. For example, if I buy a $100,000 rental unit with my money, and I receive $10,000 a year net income, my cash-on-cash return is 10 percent.
If I borrow $50,000 and am still able to receive a $10,000 return, my cash-on-cash return is 20 percent. If I ﬁnance the entire $100,000 and still receive a $10,000 return, my return is inﬁnite. Inﬁnite returns mean money for nothing. Ten thousand dollars ﬂows into my pocket, and nothing comes out. The renters cover my expenses, and I receive the income.
What Are You Investing For?
The key to more sophisticated leverage, higher returns, and lower risk is focus. Focus requires more ﬁnancial intelligence. Financial intelligence begins with knowing what you are investing for. In the world of money, there are two things investors invest for: capital gains and cash ﬂow.
- Capital gains: Another reason so many people think investing is risky is that they invest for capital gains. In most cases, investing for capital gains is gambling or speculation. When a person says, “I’m buying this stock, mutual fund, or piece of real estate,” he or she is investing for capital gains, an increase in the price of the asset. For example, if I had purchased the $17 million apartment house hoping I could sell it for $25 million, then I would be investing for capital gains. As many of you know, investing for capital gains means a tax increase in some countries.
- Cash ﬂow: Investing for cash ﬂow is a lot less risky. Investing for cash ﬂow is investing for income. If I put savings in the bank and receive 5 percent in interest, I am investing for cash ﬂow. While interest is low-risk, the problem with savings is the return is low, taxes can be high, and the dollar keeps losing value. When I purchased the 300-unit apartment house, I was investing for cash ﬂow. The diﬀerence is I was investing for cash ﬂow using my banker’s money for a higher return on investment and paying less in taxes. That is a better use of leverage.
Solving Money Problems Makes You Smarter
When I was a young boy, rich dad said to me, “Money problems make you smarter… if you solve the problem.” He also said, “If you solve your money problem, your ﬁnancial intelligence grows. When your ﬁnancial intelligence grows, you become richer. If you do not solve your money problem, you become poorer.
If you do not solve your money problem, that problem often grows into more problems.”
If you want to increase your ﬁnancial intelligence, you need to be a problem-solver.
Editor, Rich Dad Poor Dad Daily