Many of us choose investments for our IRAs or 401(k)s without really understanding what we're doing. So over the years that I've been teaching about personal finance, I started using a story that would help listeners understand stocks and bonds – without me ever using the words.
So sit back with a cup of coffee (or even better, hot chocolate) and meet Freddie.
Freddie wants to start a business. He's going to open a furniture store.
What does Freddie need to get this business started? You might be thinking that he needs a location, he needs inventory, etc.. But it all boils down to money. He needs money to get the business started.
Aunt Jane says that she will loan Freddie $100,000. The loan will be for 10 years. She asks for 7% interest, but says that Freddie can make interest-only payments and then pay the full $100,000 back at the end of the 10 years, like a balloon payment. Freddie thanks her with a big hug.
Freddie approaches his friend George about loaning him money for the business, but George isn't interested in loaning money. If he puts money into the business, he wants to be part owner. Freddie agrees, and George buys 25% of the business by putting in $100,000.
Freddie's Finest Furniture holds its grand opening. It turns out that Freddie is a master businessman. Plus, it was a good time to be in the furniture business. The economy is good. Lots of young adults are moving out of Mom and Dad's house into their own place. Home building is booming, and everyone seems to need furniture.
Each year, Freddie faithfully sends Aunt Jane two checks for $3500 each, to pay her the $7000 interest he owes her. At the end of 10 years, he's paid her a total of $70,000 in interest. He writes her a check for $100,00 and happily pays off the loan as agreed.
Around the same time, George decides that he wants out. The business has done really well, and he and Freddie have gotten along fine. They've opened new stores all over the Midwest and built an excellent reputation. But he's ready to move on to other things.
The business is now worth $2,000,000. That means that George's 25% share is worth $500,000, and he finds a buyer who's willing to pay that price.
George is thrilled. He tells everyone about his $400,000 profit.
Word gets back to Aunt Jane, and she's NOT very happy. She marches over to the store and confronts Freddie. "How come George deserves to make $400,000 profit, when all I got was $70,000?" she fumes.
Freddie keeps his cool and explains it this way:
"Aunt Jane, what if the business hadn't done well? Say that after five years, business was so bad that I had to close the store. By the time I settled the lease, sold off what was left of the stock, and laid off the employees, what if $50,000 was all that was left?
"Lenders get paid before owners. So you would have gotten paid before George. You would have gotten the whole $50,000. Of course, that means you would have lost the other $50,000.
"But George would have lost his entire $100,000, because there was nothing left; 25% of nothing is nothing!"
Aunt Jane's face relaxes as she understands Freddie's point. "What you're saying is that George took a lot more risk and that's why he was entitled to the reward, is that it?"
"Exactly," says Freddie.
But Aunt Jane has the last word: "Well, I KNEW you would be a success. So there wasn't really any risk." She turns on her heel and walks away.
If you understand how Aunt Jane's loan to Freddie's Finest Furniture worked, you understand bonds. Bonds are loans that businesses or government entities issue to raise money. They have a fixed interest rate and a maturity date. Until the bond matures, the bond owner gets interest payments. At maturity, the bond owner gets back the original investment – assuming the business has the financial ability to meet those obligations.
George's investment, on the other hand, is like a stock. He owned a part of the business. If you own a stock, you own a part of that business. If the business does well, you will be able to sell your stock at a profit. If the business doesn't do well, you might end up having to sell the stock for less than what you paid for it and take a loss. If the business fails, you could even lose all your money.
There's more to know about stocks and bonds, of course. But now you have the basics.
This is the first in a series where I'll be explaining some of the basics of investing. Next month, we'll use Aunt Jane and George's experience to learn more about the different risks that stockholders and bond owners face, plus additional ways that they might make money on their investments.
You can also listen to Freddie's story in a recording of a Money Smart Week webinar I presented for the Federal Reserve Bank of Chicago.
~Karen