How Stocks Work

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Way back in the early '90s I watched the comics industry boom and then bust. I didn't really understand why at the time, but I could smell the madness in the air and even then it seemed obvious that whatever was happening wasn't sustainable.

Several years later I watched with amazement as people ploughed their money into the .com boom, investing in companies that quite obviously weren't going to make any money because it seemed that the stock market could never fall. I have to admit that I engaged in not a little [schadenfreude] when the whole system came crashing down.

I knew a teeny amount about the way that the market worked then, and I've learned a little bit more along the way, and I hope that I can explain it in a way that makes it obvious why the stock market behaves in such a ludicrous fashion.

First, though, lets look at those comics. Once upon a time there was a stable, dull, low price market in back-issues of comics. Once a comicís been read itís basically got a cost of zero Ė itís waste paper. Any value it has is purely sentimental, whether itís the first issue of Batman or a treasured childhood issue of Spiderman. Obviously, some of these back issues are incredibly rare, so they tend to be worth more, but most of them arenít really worth much at all.

One day, in the early nineties, something changed. Whether it was a case of now grown-up readers tracking down their treasured memories, or the sudden realisation that some of the favoured writers/artists had lots of older, undiscovered, work, back issues were suddenly hot stuff. Prices fluctuated quickly and people found themselves owning a collection that was suddenly worth real, actual money. It was obviously small potatoes compared to the larger collectables market, but prices were going up across the board.

And then the collectors market noticed that comics were suddenly doing big business. The investors appeared, trying to find out what they should buy in order to make money in the long term. Comics prices grew exponentially, vast rumours spread like wildfire as to what was hot (the answer seemed to be everything) and people began buying multiple copies of comics Ė one to read and a few for investment. Print runs went through the roof. It became de-rigeur to restart comics numbering at issue 1, foil emboss covers and cross-over with major characters in order to show how hot your title was. In the end, some titles were printing five copies for every one that was actually being read.

And then the market collapsed in the space of about 2 months. Collectors realised that none of their investments were worth anything if everyone was buying multiple copies. The chances of a rare find were zero because everything was so hyped. The collectors fled the market and shops were left with hundreds (or thousands) of comics that they couldnít sell. One of the two major distributors went under. Shops across America went under and even ones on this side of the Atlantic (where the madness wasnít quite so bad) had money problems. Ordinary readers, fed up with the marketing madness that ruled for a couple of years, had abandoned comics, unnoticed when all the investors were there but sadly missed now that they were gone. There were worries that comics as a medium had died.

In retrospect, this shape is very familiar. Itís a classic boom/bust. But why does it happen? And are the reasons behind collector fads and stock market movements really comparable? When the dotcom boom happened, I was a developer working in database development in a small company in Scotland. I looked at all the fantastic stuff being developed around the internet and was amazed. Partly I was amazed that something Iíd been using personally for 10 years was suddenly mainstream but largely I was amazed that people were actually investing money in companies that would ship pet-food across the country to you. Later, I was amazed that prefixing the letter Ďeí onto anything could make it valuable and that adding .com on the end transmuted any substance into gold.

Letís take a look at how shares work and see if that can explain it. Iím going to use vastly simplified amounts of money to make it easier to visualise.

Letís say that Iím starting a company. I want to build framistats, but in order to do so I need to raise £10,000 to buy the necessary tools, etc. So I get together with 9 of my friends, we each chip in a thousand pounds and use that as the startup costs. Now, we each own a tenth of the company. But that doesnít actually do a lot for us unless we get something back for it. So we agree that a proportion of the profits from the business will be paid to each of us every year. Seems simple and reasonable, doesnít it?

Now, imagine that the company is profitable (hard to imagine at the moment, but lets do our best) and makes £5,000 a year in profit. Obviously we want to invest some of that back in to the company so that we can buy new tools, hire new people, etc. So we plough half of it back in and split the other half amongst us, giving us £2,500/10=£250 each.

Now, after a year, one of the investors wants to sell his share (the reason why isnít important). How much is it worth? Well, the fact that it originally cost £1000 isnít important, whatís important is what you can get for the share - £250 a year (assuming that nothing changes). Now, a quick check shows that a bank account will pay about 3% interest at the moment, meaning that if you put your money in it would take 25 years to double your money (compound interest is a marvellous thing). Letís assume that we want to make our money back on our investment in 20 years, that means that the share is worth 20x£250 or £5000. Obviously Bob is a happy man. Heís lucky too, most new businesses go bust, which would have lost him all of his investment.

Basically thatís how shares in a company work Ė you look at the yearly payout (or dividend) and work out how much the shares are worth. Thereís complications based on how risky a company is Ė some pay out large dividends one year but then smaller ones for a few years afterwards, others pay out regular amounts year on year. Risky shares are generally worth less because most investment money comes from large institutions (like insurance companies) which donít like explaining how they lost their customerís money.

So, if shares are so simple, why do stock markets keep booming and busting? Why do some people make a fortune on investments while others lose their shirts?

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Last edited April 10, 2004 4:08 pm by AndrewDucker (diff)