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I have many people jumping into the investing scene as of late, probably because the same reason people jumped into bit coins as FANGs make all time highs and Tesla holders became rich over a few months. Through this hysteria, I have noticed that many people I talk to doesn't understand the purpose of stock investing, or what a stock is. So I came up with this analogy to shed some light on the matter. It may be common sense to most but I'm sure some new investors may find this useful.
Jimmy wants to start the world's first slow churned ice cream shop because he wants the world to experience how delicious it is vs conventional methods. This project will cost Jimmy 100k. He only have 20k, so he calls up all his friends and family to see if they are willing to invest. YOU decides that it's a good idea, but also a risk..but you know how Jimmy is an extremely hard worker and tried out his ice cream, you decide to throw in 10k for 10% of the company. Jimmy is willing to share 10% of his profits with you if he makes money.
So for 10k, you own 10% of Jimmy's single ice cream shop and maybe get a 10% dividend of all the profits after expenses.
Jimmy found his shop to be very successful, but instead of passing down the profits to all his investors, he decided to use the profits to build 9 more ice shops. Your value of 10% shares of the company went from 1/10th of 1 ice cream shop to the value of one ice cream shop out of 10. Outside people watching the story unfold wants their money to grow as well, so they are willing to pay way more money for you to sell your stake. They start the bidding war, trying to get you to sell because people speculates and sees Jimmy expanding probably to 500 shops one day, or maybe 5000 shops.
So 10 years later, Jimmy's ice cream has 5000 shops and reached saturation so all the profits will be distributed to the shareholders as promised. If you decided to hold and not sell to other speculators, your 10% share is now has the value of at least 500 ice cream shops plus 10% of the profits Jimmy promised you from all of his ice cream shops in the form of a dividend. Now some people are willing to pay you more than what your shares are worth to capture the dividends Jimmy is distributing until it reaches an equilibrium.
Because Jimmy was so successful, Joe wants to open up a similar ice cream shop. Of course it'll cost 100k to get started, and he needs investors to help him. Because so many people saw how you invested into Jimmy's shop and now became millions of dollars rich, everyone is tripping over each other trying to throw money at Joe, bidding up the price way beyond what he needs for his ice cream shop. Everyone thinks Joe's ice cream shop will be the next Jimmy's, and fantasize the potential growth of their money. Before Joe even finished opening his first one, he already have millions of dollars in the bank from investors, hoping he would open up ice cream shops as fast as possible. However the risk is, we don't know if Joe's shop can even capture a the market share from Jimmy...but people don't seem to look very far down that path.
Now you know
-what a stock is
-the purpose of investing
-why stock values go up (and can go down if Jimmy opened less than expected amount of shops)
-why people are willing to pay more or less for your stock
-why the market is forward looking
-why there's unreasonable exuberance when there's a copy cat company
Jimmy wants to start the world's first slow churned ice cream shop because he wants the world to experience how delicious it is vs conventional methods. This project will cost Jimmy 100k. He only have 20k, so he calls up all his friends and family to see if they are willing to invest. YOU decides that it's a good idea, but also a risk..but you know how Jimmy is an extremely hard worker and tried out his ice cream, you decide to throw in 10k for 10% of the company. Jimmy is willing to share 10% of his profits with you if he makes money.
So for 10k, you own 10% of Jimmy's single ice cream shop and maybe get a 10% dividend of all the profits after expenses.
Jimmy found his shop to be very successful, but instead of passing down the profits to all his investors, he decided to use the profits to build 9 more ice shops. Your value of 10% shares of the company went from 1/10th of 1 ice cream shop to the value of one ice cream shop out of 10. Outside people watching the story unfold wants their money to grow as well, so they are willing to pay way more money for you to sell your stake. They start the bidding war, trying to get you to sell because people speculates and sees Jimmy expanding probably to 500 shops one day, or maybe 5000 shops.
So 10 years later, Jimmy's ice cream has 5000 shops and reached saturation so all the profits will be distributed to the shareholders as promised. If you decided to hold and not sell to other speculators, your 10% share is now has the value of at least 500 ice cream shops plus 10% of the profits Jimmy promised you from all of his ice cream shops in the form of a dividend. Now some people are willing to pay you more than what your shares are worth to capture the dividends Jimmy is distributing until it reaches an equilibrium.
Because Jimmy was so successful, Joe wants to open up a similar ice cream shop. Of course it'll cost 100k to get started, and he needs investors to help him. Because so many people saw how you invested into Jimmy's shop and now became millions of dollars rich, everyone is tripping over each other trying to throw money at Joe, bidding up the price way beyond what he needs for his ice cream shop. Everyone thinks Joe's ice cream shop will be the next Jimmy's, and fantasize the potential growth of their money. Before Joe even finished opening his first one, he already have millions of dollars in the bank from investors, hoping he would open up ice cream shops as fast as possible. However the risk is, we don't know if Joe's shop can even capture a the market share from Jimmy...but people don't seem to look very far down that path.
Now you know
-what a stock is
-the purpose of investing
-why stock values go up (and can go down if Jimmy opened less than expected amount of shops)
-why people are willing to pay more or less for your stock
-why the market is forward looking
-why there's unreasonable exuberance when there's a copy cat company
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