How NOT to Be an Average Investor
If you want to get rich investing in the stock market, you have to have different investment strategies than the average investor.
In the world of investing, there are always professionals and amateurs. The stock market is a great place for professionals because there are so many amateurs who are forced to be in the deep end of the pool where the sharks wait.
When it comes to the stock market, the biggest difference between amateur investors and professional investors are:
- How they seek to generate income.
- How they manage risk.
The interesting thing is that most people only know of one way to invest in the stock market, so they never ask the question of how they should do it.
But the reality is that there are three main ways to go about stock investing. The trick to getting rich investing in the stock markets is to match your investing goals with the right investment strategies.
3 Stock Market Investment Strategies
As a stock investor, there are three ways you can use the stock market to accomplish your goals:
- Capital gains: buy a stock share at a low price and sell it at a higher price — the difference between your buy and sell price is your gross profit.
- Cash flow: have a stock portfolio that pays out dividends or buy a stock share and option it to earn income for ongoing cash flow.
- Hedge: buy insurance (options) on your stock share to protect it.
All three of these are valid ways to make money. It’s important that you know about these different strategies so you can make smart decisions.
Investing for Capital Gains
If stock investors want to increase their net worth with stocks, they can buy shares and hold them in their portfolio, hoping they increase in value. Many people are already doing this through retirement plans such as a 401(k), an IRA, and mutual funds.
This is the most common way to invest in the stock market. It’s what most people have in mind when you talk about how to invest in the stock market. And it’s also the worst way to do it.
One disadvantage of paper assets in the United States is the inability to defer taxes on capital gains. Years ago, it was possible to 1031-exchange stocks and to defer capital-gains taxes. That tax loophole was closed for paper assets but kept open for U.S. real estate investors.
Investing for Cash Flow
In real estate, the battle cry is usually “location, location, location.” It seems that in paper assets the battle cry is “diversification, diversification, diversification.”
In my opinion, in both real estate and paper, the battle cry should be “cash flow, cash flow, cash flow.”
If your goal is to generate cash flow, you may want to use the strategy of selling options to meet your cash flow goal. Cash flow is valuable to you because it’s how you are able to feed your family and pay your bills.
Simply having an asset that increases your net worth does nothing to improve your cash flow situation. There are many people who are rich on paper but poor in cash. Lots of people found that out the hard way when the dot-com bubble popped in the early 2000s. Thousands of “millionaires,” people who had stock options in high-flying tech companies, became “poor” overnight.
That’s why I people around the world to think differently and seek assets that give them cash flow.
When you have assets that generate cash flow for you, it can help you now and through retirement. Remember: Net worth doesn’t help you retire; cash flow does. Your net worth doesn’t pay the bills; the cash that comes into your bank account each month does.
That’s an important distinction to make. If you are selling options on your stocks, that is cash flow that goes into your income statement. It’s an important addition to your income statement that can transform your life.
Investing for Hedging
Your third investing strategy is hedging, which is essentially buying insurance on investments. When you buy an investment such as a house, you certainly don’t want to lose that investment. No matter the reason behind your purchase, it’s important to protect it. If the house burns down, the insurance you bought guarantees that your investment will be safe.
In 2007, it disturbed me deeply to watch the stock market crash, knowing the consequences for millions of investors, investors who believed that the stock market always goes up over the long term and that diversification was insurance against losses.
Professional investors invest with insurance, even in the stock market.
Hedging is simply a purchase that protects you if something bad happens to your primary investment. So, if your goal is to protect what you have, then hedging is the strategy you’ll want to deploy.
Buying insurance doesn’t put money in your pocket. It’s an expense. But smart investors protect their investments with insurance.
Many people don’t realize that you can buy insurance on your stock investments, but you can. Just as you can use stock options to gain cash flow, you can also use them to protect against lose in your stock portfolio.
Capital Gains Vs. Cash Flow
Let’s take a look at the difference between investing in the stock market for capital gains vs. cash flow.
Maybe you want to buy stock in Acme and you buy it at $100 a share. Let’s say that after a while Acme is now worth $200. Now your net worth has gone up. You have more wealth than you did before—but you are not wealthy. Your “assets” have grown, but Acme has not given you any income; there’s no cash flow from it.
While it’s nice to have an asset worth more than when you bought it, it could very easily go down again. If you need help to pay your bills or mortgage, it will make no difference if your asset is worth more. The only way it can help you is if you sell it… and then you no longer have an asset, just cash.
But suppose you buy a stock that pays you a regular dividend. Now you own an asset that is also adding to your cash flow without you having to do a thing for it. With enough assets like this, you can eventually have the income to do whatever you like right—now or in retirement. In my opinion, that should be the overall goal of investing: freedom of choice and lifestyle.
The best way to reduce risk is by taking control. And that starts with your financial education. The more you know, the greater control you have over your life and finances.
Risk is real. Accidents, mistakes, and crimes happen every day. One of the reasons the rich get richer is that they take control of their financial education, rather than avoiding risk and believing in job security, saving money, safe investments, fair share, mutual funds, diversified portfolios, and being debt-free.
Risk is increasing, and it’s tied to uncertainty. With economic uncertainty, the rise of China, and the decline of the West, risk will increase because uncertainty is increasing.
True financial education gives you more control over risk.
To Be Rich Is to Be Free
Suppose you have monthly bills of $4,000. You need to cover these expenses every month. You need income-producing assets to produce cash to cover your expenses—this is true financial freedom.
That’s a goal! That is wealth. That is being rich. Wealth is when you have passive income to cover your $4,000 in expenses. That is why cash flow is the key to wealth.
Some confuse financial freedom with high net worth. If you have a high net worth, you may be rich but you may still have to work. You can be rich in net worth and not be able to pay your bills. You can have a million dollars in a 401K and not be able to cover your monthly expenses for the rest of your life.
But if you have passive income that exceeds expenses, then you’ve become independently wealthy. In other words, you have enough wealth to be independent of having to work.
So if you want to get rich from investing in the stock market, then learn to invest for cash flow and to hedge against your losses with options contracts. This takes a level of financial education, but investing in growing your financial knowledge will be well worth it. It’s the only way to get rich after all.
Play it smart,
Editor, Rich Dad Poor Dad Daily