GameStop, Retail Investors, and the 10 Controls of the Sophisticated Investor

In an increasingly unpredictable market for investors, these 10 controls are essential for maximum investment success

It’s been a wild week on Wall Street. Chances are that even if you don’t follow the stock market, you’ve come across any number of stories on the incredible rise of GameStop’s stock prices, and to some extent AMC and a handful of other companies.

On Friday, January 29, 2021, GameStop’s stock went as high as $380 and became one of the most traded stocks on the market. How did this happen to a mall store with a stone-age business model in the middle of a pandemic?

Hedge funds vs. retail investors

The events of the last week are the result of a power struggle that has been brewing for years, the rich vs. the poor. The establishment vs. the populist.

Over the last decade, programmatic trading using sophisticated technology has allowed hedge fund managers to exact enormous profits by short selling companies that they believe will fail. At the same time, using websites like Reddit and new financial technology apps like Robinhood, amateur investors (or what the media calls retail investors, those who day trade to try and get personal gains) have quietly built a rebellion against hedge funds.

This all came to a head last week.

As MSN Money writes:

The internet has been used to prognosticate about stocks for decades, but there's never been anything quite like the Reddit community called r/wallstreetbets, also known as WSB.
WSB takes something of an internet extremist's approach to investing. Its slogan is "Like 4chan found a Bloomberg Terminal," alluding to the fringe message board and the Bloomberg computer system that is nearly ubiquitous in finance.
Amateur investors on WSB have discussed GameStop (which they refer to by its stock ticker abbreviation, GME) for years, but things changed early this year. As the price of the shares rose, more WSB posters jumped on board. "100% of my portfolio on GME because of you idiots," a person posted Jan. 10. On Wednesday, the people who run WSB temporarily made the community private and said they were "experiencing technical difficulties based on unprecedented scale as a result of the newfound interest in WSB."
There's also Robinhood, the app that is the unofficial stock trading platform of choice for WSB. It lets people trade stocks and even more exotic investments, like options, for little or no charge.

As a result, short sellers (mostly hedge funds) lost $23.6 billion on GameStop alone this month. That’s what we call a bloodbath.

What can we learn from the GameStop phenomenon

I’ve talked for a long time about the importance of control when it comes to investing. Control is the most important thing you can have as an investor. Lack of control leaves you at the mercy of market conditions. This is also why I say it’s riskier to be an employee than to be an entrepreneur. As an entrepreneur, I have more control over my destiny than I do as an employee.

One of the best ways to tell if someone is a sophisticated investor vs. an amateur investor or gambler is whether they understand how to set themselves up for the most control.

In this sense, both retail investors and hedge funds are amateurs and gamblers. This week was a perfect lesson in the importance of control. Make no doubt about it, this week the retail investors stuck it to the hedge funds. But a reckoning will most likely come to most of those retail investors and probably at the hands of the hedge funds.

Rather than get caught up in gambling to make a fortune in day trading, I’ve taught for years about how to build true wealth as a sophisticated investor.

The 10 controls of the sophisticated investor

Rich dad often spoke of the sophisticated investor. “A sophisticated investor is an investor who understands each of the ten investor controls,” he said. These ten controls were the key to making huge sums of money in the markets.

If you’ve been thinking of jumping into the fray and making a quick buck on what’s happening in the market, I’d encourage you to really contend with these 10 controls and ask yourself if you really want to be a gambler, or if you’d rather commit yourself to mastering these ten controls and becoming a sophisticated investor who builds wealth in an intelligent way over time.

Sophisticated investor control #1: Control over yourself

“The most important control you must have as an investor is control over yourself,” said Rich Dad.

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. Once you leave 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 to any given situation, that the best learning comes through making mistakes, and that financial literacy is essential to be successful. They do not become flustered when they make a mistake. Rather they have control over themselves to learn from and get better from mistakes. They know their own financial statement, and they understand how each financial decision they make will ultimately impact their financial statement.

Most important, a sophisticated investor knows when to hold back from jumping into a volatile and unpredictable market.

Sophisticated investor control #2: Control over income/expense ratios and asset/liability ratios

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.

The poor spend every penny they make and own no assets. It is simply money in and money out.

The middle class accumulates more debt as they become more successful. A pay raise qualifies them to borrow more money from the bank so that they can buy things like cars, vacations, boats, and more. As their income increases, so does their personal debt. That is what we call the Rat Race.

The rich have assets that 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 a few, if any, personal liabilities.

Sophisticated investors focus their time and energy on buying assets that put money in their pockets—not chasing liabilities that take money out. It’s just that simple.

One reason why a sophisticated investor might not jump into the GameStop craziness is because they would not be investing in assets that provide cash flow. They would simply be gambling, betting the stock price would go up—but it may also crash.

Gambling can be fun, but it’s not sophisticated investing.

Sophisticated investor control #3: Control over the management of an investment

An inside investor who owns enough of an interest in the investment to control the management decisions has this type of investor control. The investor can be a sole owner or own 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 sophisticated 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.

A sophisticated investor would know they have no control over the management of GameStop and that the gains in the stock price are not related to the business performance of the company, which actually has poor performance.

Sophisticated investor control #4: Control over taxes

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 that the sophisticated investor uses thoughtfully to minimize taxes paid and to increase tax deferrals wherever possible.

For instance, in the United States, people on the B (business) and I (investor) side of the quadrant enjoy many tax advantages that those on the E (employee) and S (self-employed) side do not.

Much of the sophisticated investor’s income is in the form of passive and portfolio income, so they do not have to pay social insurance taxes like social security and Medicare on that money.

They can use tax laws to defer tax payments, sometimes indefinitely.

They can pay for expenses with pre-tax dollars and be taxed only on the net income.

These and many other advantages give the sophisticated investor a huge head start over those investing in the E and S quadrants.

A sophisticated investor would know that day-trading GameStop stocks for short-term gains would actually be taxed at some of the highest tax rates because it would be considered capital gains.

Sophisticated investor control #5: Control over when you buy and when you sell

The sophisticated investor knows how to make money in an up market as well as a down one. In building a business, he or she 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.

A sophisticated investor would understand they have no control over when to buy or sell GameStop. They would simply have to watch the market and make a judgement call based on how much it was going up or down, often in a given day. Sure you can make the call when to sell, but that’s not true control. No one is truthfully looking to hold onto GameStop for the long run. The market conditions force your hand on when to buy or sell.

Sophisticated investor control #6: Control over brokerage transactions

Sophisticated investors who have inside influence can direct how the investment is sold or expanded.

As outside investors in other companies, sophisticated investors carefully track the performance of their investments and direct their broker to buy or sell appropriately.

Many investors today rely on their brokers to know when to buy and sell. That is not sophisticated. It's foolish. Amateurs learned this the hard way when the popular trading app, Robinhood, stopped allowing trades of GameStop last week.

A sophisticated investor would understand that the massive volatility of GameStop might cause a lack of control on when they could do transactions...and that they might get caught in the cold in the process. They would also understand that there are high fees that come with day-trading that compound the cost of the transactions on the tax side.

Sophisticated investor control #7: Control over the E-T-C (Entity, Timing, Characteristics)

“Next to control over yourself, the control over the E-T-C is the most important control,” said rich dad. 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 ordinary income into passive and portfolio income as possible. This strategy combined with the ability to read financial statements helped rich dad build his financial empire more quickly.

A sophisticated investor would understand that retail trading is capital gains that basically lives on the left side of the CASHFLOW Quadrant where entities and the law are not built to maximize gains.

Sophisticated investor control #8: Control over the terms and conditions agreement

The sophisticated investor is in control of the terms and conditions of the agreements he or she makes when 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 didn’t have to pay taxes on the sale because I controlled the terms and conditions of the agreement.

A sophisticated investor would know that the GameStop situation doesn’t allow for this type of control and would put them at risk for serious tax liabilities and losses.

Sophisticated investor Control #9: Control over access to information

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).

A sophisticated investor would understand that the price of GameStop’s stock had nothing to do with what was happening inside the company and that there would be no way to have control over the access to information that influenced the stock price.

Sophisticated investor control #10: Control over giving it back

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

A sophisticated investor would also weigh the cost of short term gains betting on crazy price fluctuations with the human impact that has on the people inside a company.

As Rajan Roy writes for the newsletter The Margins:

"Gamestop is a real company. It has over 53,000 employees. There's a reason you have not heard from anyone at Gamestop. This must be terrifying."
...
Gamestop's CFO is a guy named Jim Bell. I feel he might go by Jimmy B. He was formerly the CFO of the PF Chang's holding company (awesomely named Wok Holdings). He was a Naval Officer. Jimmy B. seems like the type of guy you'd want to handle such a high-pressure situation.
But when that stock starts absolutely tanking - what happens? Does it stop exactly at some reasonable enterprise valuation? That's not how momentum works. In trading, everyone loved the adage "don't try to catch a falling knife" but while everyone enjoyed the lulz on the way up (other than Melvin Capital), it will be Bell's job to catch the knife on the way down to try to keep as many of these people still employed as possible. Whatever happens, it will [be] dangerous and ugly. Real employees could lose their real jobs thanks to the lulz.

Again, gambling can be fun, but it can have real consequences both for you and for others. And it should never be confused with sophisticated investing.

You could jump onto the GameStop crazy train. I can’t stop you, obviously. But I would encourage you to consider the risk and the cost. I think your time could be better spent mastering the ten controls of sophisticated investing.

Are you ready to become a sophisticated investor? It starts with financial education and good coaching. Start today.

Original publish date: June 16, 2015