American author and motivational speaker Tony Robbins once said: “success in life is 80% psychology and 20% mechanics”. Understanding how our mindset can affect what we do and our decisions can play a significant role in our success. It is much harder to succeed without the right mindset, and this same principle also applies to financial education and basic rules of investing.
Ultimately, everything boils down to six fundamental principles and the attainment of a sound financial education. Let’s take a closer look at these ideas, how you may apply them to your personal financial situation, and how to produce money from your assets rather than working for it.
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Basic rules of investing
Investing is the act of acquiring assets like stocks, bonds, shares, real estate, or commodities with the aim to either sell them at a higher price in the future to make a profit or for the assets to generate passive income for them in the long run.
People can actively invest and manage their own investments, or choose to use a financial advisor. Investors can choose passive investing through fixed-income assets like bonds, or buy into stocks that require more attention and work.
Often, the first thing that comes to mind with investing is a risk. Deciding your strategy depends on your risk tolerance and how much time and work you are willing to put in. It can require a change from the traditional mindset and behavior.
That’s why anyone with some savings can invest but should have a proper understanding of what it is and know these basic rules of investing:
- Other people’s money (OPM);
- Main types of income;
- Financial education;
- Invest in cash flow;
- Investing is risky;
- Learn how to raise capital.
Below, we have detailed these six fundamental rules of investing in detail below to assist you in achieving success and mastering the markets.
1. Other people’s money (OPM)
Other people’s money or OPM is a jargon expression used in the business world to describe financial leverage or third-party financing, usually to buy real estate or other assets that can grow in value over time.
Financial leverage is borrowed capital used to increase the potential returns, thus also increasing risk. OPM enables a borrower or investors to acquire, control, or improve assets to increase their value and profit beyond their original resources (the capital they currently have).
Or, in simple terms, borrowing money from a bank to buy assets that can grow in value to make a profit, commonly used in finance and by entrepreneurs.
OMP means that no equity is used but is covered by a loan. It can be either a loan from a bank or a private loan – any money that doesn’t come from the borrower’s pocket.
A good example is borrowing money from a bank to invest in property, with the aim to either rent it out at a rental fee that exceeds the loan payment or renovate it to sell the property at a higher value, making a profit.
However, it can go both ways – if the investment decision isn’t good and well thought through, the process can also result in high losses. Therefore, using OPM requires a lot of financial understanding but is one of the most feasible ways to grow wealth.
Financial leverage example
Most of the time, investors use a mix of debt and equity financing. Borrowers put down a deposit (their own money) and take out a loan to cover the rest to buy the asset.
For example, if an investor has put down $1,000 on an asset, this asset may gain or lose 20% in value in the future. If the acquisition grows by 20% in value, they earn a profit of $200, and if the asset decreases by 20%, the investor loses $200.
With debt financing, if an investor borrows an extra $4,000 on top of his original cash investment of $1,000, they invest a total of $5,000 in this same asset. As the sum is higher, if the asset gains 20%, the investor earns a profit of $1,000, a return of 100% from his equity.
Similarly, if the asset loses 20%, they lose $1,000, representing a loss of 100% of the original investment. And it doesn’t stop there, and losses can always be higher than 20%, meaning that the loss will exceed the equity invested, dipping into the money borrowed, thus increasing the risk.
As you can see, OPM is an excellent financial tool to generate more money in combination with the existing cash. Using debt to finance investments can generate higher profits and is a way of making existing money go beyond available cash, but it can also increase risk at the same time.
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2. Main types of income
To shift from the 9-5 mindset and successfully make your existing money grow, it is important to understand three main types of income. Most people make money through earned income; any job where people work certain hours for a salary – teachers, marketers, firefighters, lawyers, and is often the highest taxed.
Understanding basic types of income can help understand how to save money for retirement beyond traditional pension funds, invest in real estate and stocks, earn more passive income, generate wealth without having to work, become an entrepreneur, turn your hobbies into a business or a side income, or be generally financially aware.
As most individuals don’t think about how to pay less tax or understand how to generate passive income – money gained while not working, we need to understand the basic types of income. When it comes down to the basic rules of investing, there are three types of income:
Earned income
Note
There are two categories of income: active and passive. Earned income is active income, as you have to work to make that money actively.
Most people fall into this category, and it is the first place to start earning capital to invest. However, the next step is to know how to invest and grow that money passively. Often, the lack of knowledge comes from the lack of financial education.
Earned income is one of the highest-taxed incomes; back in 2021, the average corporate income tax from over 180 jurisdictions worldwide was at a high of 24%. Even high-paid salary jobs in any profession are salaried income and come at a high tax rate, for example:
- Teachers;
- Lawyers;
- Doctors;
- Marketing;
- Sales;
- Tech;
- Construction.
It is important to understand that money earned in this category can only grow so much, as people can only work a limited amount of hours. Other types of income are necessary to complement it and make existing, earned income grow.
Portfolio income
Note
One way is earning dividends or capital gains through investing in paper assets like stocks, mutual funds, or even 401(k), with investments often guided by a financial advisor. Flipping houses is another good example of portfolio investment, buying a property at a lower price, doing it up, and selling for a profit.
Capital gains cluster into two: short-term and long-term. In the US, for example, profits from short-term capital gains (stocks that are held and traded for one year or less) are taxed at the usual salary income rates. In contrast, long-term capital gains are generally taxed lower, at either 0%, 15%, or 20% depending on the taxable income.
Many people use this type of income to save up for their retirement or to generate extra income. Some examples include:
- Becoming a shareholder in a company;
- Buying and trading stocks, exchange-traded-funds (ETFs), index funds;
- Putting money in savings accounts or bonds;
- Investing in peer-to-peer (P2P) loans;
- Flipping houses.
Passive income
Note
Passive income can be money earned through rental properties, a limited partnership, a business, or receiving royalties from a book or an online course.
For example, you have created and launched an online course, you then charge $100 for each download. Since you have already put in the work, this course will keep generating passive income in the future without having to do more work.
However, it is essential to note that even these gains come taxed, but the good thing is that they are often lower, and many things deducted. For example, in real estate, depreciation, maintenance, upkeep, or repairs reduce the taxable amount.
A few more examples of passive income:
- Royalties from online courses or book sales;
- Leasing any equipment;
- Earning money from rental properties;
- Limited partnership business owner;
- Affiliate marketing through a blog or website;
- Sell graphic designs.
3. Financial education
There tends to be a lack of financial education in schools and universities. What is taught is financial literacy, but what is not is how money works and how to make money work for you – financially educating yourself is one of the basic rules of investing.
Financial education is about knowing how to leverage debt, assets, liabilities, and cash flow, not only what income and expenses are. Understanding the basics of accounting processes and cash flow management can also help.
In conventional education, people are told to study hard, get a high-paying job, work hard, pay their taxes, and pay off their debt. However, entrepreneurship and passive income avenues aren’t as widely discussed, leaving them unaware of the importance of other possibilities. Therefore, financial education in combination with academic and professional studies is essential.
The ever-increasing wealth gap means young people now earn less income compared to their parents or grandparents’ compared to the overall cost of living: high rent, buying a house, having to pay off ridiculously high student loan debts.
However, the overall sentiment is beginning to change – about 45% of Millennials are more interested in investing than they were a mere five years ago, found the BlackRock survey from back in 2020.
Millennials and Gen-Z are digital natives, with technology a part of their everyday lives, enabling them to turn their hobbies into passive income streams, quickly set up their own businesses, or financially educate themselves.
The reality is that global debt will keep increasing, accelerated by the Covid-19 crisis. One survey observed the most significant surge in debt in 2020 since World War II, with global debt rising to a whopping $226 trillion. Rising debt also means an increase in tax and inflation rates and a decrease in job security.
Therefore, educating and knowing the basics of accounting processes and cash flow management is crucial when investing.
4. Invest in cash flow
Cash flow in a business sense means the amount of money coming in and going out of a company – money earned from sales as revenues and money spent on costs as expenses. It can also refer to passive income from assets – investing in cash flow means acquiring assets to earn ongoing income, like rental flats or royalties.
People dream of a big house and a car, and due to changing economic conditions, it is getting harder to do so with only earned income. Investing in assets, people can earn additional, passive income that grows the earned income.
A crash course in accounting can be a helpful tool to those unfamiliar with financial terms and how money works to invest successfully. The key is the shift in the mindset: work to acquire assets rather than work for money. Work to earn money to use that money to invest in assets that can generate consistent income in the long-term in the future.
Let’s have a look at the traditional four cornerstones: Income and Expenses, Assets and Liabilities:
To expand on it, let’s now have a look at how the author of the bestseller personal finance book “Rich dad, poor dad” Robert Kiyosaki’s views these four cornerstones: Income and Expenses, Assets and Liabilities, combining them with cash flow statement:
Kiyosaki’s cash flow chart highlights the differences between the middle class and wealthy people’s way of thinking. The idea is that the rich are aware of the difference between an asset and liability and buy assets to earn income from those assets, instead of earning income from a high salary, which is also the highest taxed.
An entrepreneur has to know how to increase their income, know precisely how much tax they have to pay and create assets, whereas employees would never have to be aware of these things.
To truly build wealth, Kiyosaki suggests:
- have better cash flow management;
- differentiate assets and liabilities, buy into assets, not liabilities;
- salary is taxed highest, and high-income leads to higher taxes;
- acquire income-generating assets.
5. Investing is risky
Investing is risky, but what is risky depends on how you define it. Working a high-paid 9-5 job can also be risky, as one can get made redundant at any time with no backup plan.
If that happens, income from assets acquired becomes important as additional income. Well, being made redundant from a job while having made a wrong investment decision doesn’t sound ideal either? Financial education ties into everything, which is why it is so important. Both the shift in mindset and financial, educational awareness empower our decisions to live a good financial life.
For example, investing in real estate can be risky, but through learning, knowledge, and experience, people can make sound thought-through, and realistics decisions on where and how to best invest.
6. Learn how to raise capital
Raising capital can be intimidating, and it takes intelligence and learning, effort, and creativity to raise money.
In Robert Kiyosaki’s book, “Rich dad, poor dad,” the rich dad suggests that there is always a way to find the money for it with a good investment deal. It is harder to raise capital because it involves being prepared, becoming well informed, educated, and experienced.
But this process would educate and help to become a good/better investor because one has to figure out how to afford it in the first place and learn in the process. Investing own capital is easy, so the key here is to be a good investor, and one has to educate themselves first.
Conclusion
The main rule of investing is to obtain a proper financial education and change the mindset that comes with it. Financial education helps to make well-informed and intelligent investment decisions.
Firstly, to understand how to use financial leverage, know the difference between different types of income, how to grow that income, and how accounting and cash flow work are all basic rules to master to invest successfully.
To master these rules, find the right teachers, educate yourself through various online resources and courses, and gain experience.
Read also:
15 Top-Rated Investment Books of All Time
10 Best Stock Trading Books for Beginners
Disclaimer: The content on this site should not be considered investment advice. Investing is speculative. When investing, your capital is at risk.
FAQs
What is investing?
Investing means buying into assets with the aim to generate profits as they go up in value. It is the act of acquiring various types of securities and assets such as stocks, bonds, real estate, or commodities like gold, silver, or grains, to either sell them at a higher price in the future or generate profits in the long term.
What are the basic rules of investing?
Often what comes to mind with investing is risk, but with proper education and understanding of the basic rules of investing, one can figure out how to adjust their strategy to their risk tolerance and mindset. Knowing the following basic rules of investing from an entrepreneurial viewpoint can help change that:
- Other people’s money (OPM)
- Main types of income
- Financial education
- Invest in cash flow
- Investing is risky
- Learn how to raise capital
What are the main types of income?
One of the six rules is understanding the three basic types of income. Earned income, as the name suggests, is where employees work certain hours for a salary income. Portfolio income is where people invest in stocks or real estate with the aim that they go up in value to then sell them at a higher price. Passive income is money coming in regularly, for example, income from rental properties, from a business or a limited partnership, or royalties from an online course or a book.
What does it mean to invest in cash flow?
Cash flow in investing refers to passive income from acquired assets. Investing in cash flow means to buy assets that can generate money ongoingly, for example, through rental flats or royalties. Cash flow is using the existing funds to turn earned income into passive income, by buying assets that can create consistent income in the long-run.
