Willie Wonka’s Chocolate Factory and Stock Market Profits

This post is a ‘sneak peak’ at the book I’m writing…enjoy!  Andrew

If you were fully invested in the stock market over the past 20 years, you would have made nearly 10% annually on your money, despite the “recent” 10 year flatlining period–if your fees were low and if you reinvested all of your dividends.

But the market’s a mystery to many people. How does it work? Where does the money come from? Understanding Willie Wonka’s chocolate factory should help to clarify it.

Imagine Willie Wonka starting off with a little chocolate shop. But he had big dreams—to make ice cream that didn’t melt, chewing gum that never lost its flavour and chocolate that even the devil would sell his soul for.

But Willie didn’t have enough money to grow his factory. He needed to buy a larger building, hire more workers, and purchase machinery that would make chocolate faster than he ever could before.

So Willie hired someone to approach the New York Stock Exchange, and before Willie knew it, he had investors in his business. They bought parts of his business, also known as “shares” or “stocks”. Willie was no longer the sole owner, but by selling part of his business to new stock holders, he was able to build a larger more efficient factory with the shareholder proceeds—which increased the chocolate factory’s profits because he was able to make more chocolate and treats at a faster, more efficient rate.

But because Willie’s factory was now “public”, it meant that some of his original business partners (the other stock owners) could sell their portions of Willie’s factory to other willing buyers. In fact, any of the owners could sell their stocks and new investors could buy them. But Willie and his business weren’t affected by this buying and selling because the business never had to pay anyone.

When a publically traded company has shares that trade on a stock market, the trading activity doesn’t affect the business. So Willie, of course, was able to concentrate on what he did best: Willie Wonka made chocolate. And the shareholders didn’t bother him because generally, shareholders don’t have any influence in a company’s day to day operations.

And Willie’s chocolate was amazing. Pleasing the shareholders, he began selling more and more chocolate. But they wanted more than a certificate from the New York Stock Exchange or their local brokerage, suggesting that they were partial owners of the chocolate factory. They wanted some of the business profits that the factory generated. And this made sense because stockholders in a company are technically owners.

So the board of directors (which was voted into their positions by the shareholders) decided to give the owners an annual percentage of the profits, known as a dividend, and everyone was happy. This is how it worked: Willie’s factory sold about $100,000 worth of chocolate and goodies each year. After paying taxes on the earnings, paying for their worker’s wages, paying for maintenance on the building and equipment, Willie Wonka’s Chocolate Factory made an annual $10,000 profit, so the company’s board of directors decided to pay shareholders $5000 of that annual $10,000 profit and split it among the shareholders. This is known as a dividend.

The remaining $5000 profit would be reinvested back into the business—so Willie could pay for bigger and better machinery, advertise his chocolate far and wide, and make chocolate even faster, while generating even higher profits.

And those reinvested profits made Willie’s business even more profitable because he was able to advertise more, buy better equipment, and do market research on what kind of chocolates the public wanted to buy. Instead of making profits of $10,000 a year, The Chocolate Factory started making profits of $20,000 a year—making all of the owners happy.

This of course, made other potential investors drool. They wanted to buy shares in the factory too. But there were more people wanting to buy shares than there were people who wanted to sell shares. This created a demand for the shares, and the share price, on the New York Stock Exchange rose because of this issue. It’s very easy to explain the price changes of something on the stock exchanges. If there are more buyers than sellers, the stock price of a business rises. If there are more sellers than buyers, the price of the business’ shares fall.

And every day, the shares on the stock market for Willie’s factory would fluctuate. Sometimes, the public saw only the great things about the chocolate factory, so the demand pushed the price up. And on other days, investors grew pessimistic, and the price would fall.

Willie’s factory continued to make more money over the years, and his profits rose. And sometimes, the share price of his factory would fall, and sometimes it would rise, but over the long term, when a company makes more money, the stock price generally rises along with it.

So investors could make money two different ways: they could make money from dividends (cash payments given to shareholders usually four times each year) or they could wait until their shares had increased a lot on the stock market, and choose to sell some or all of their shares.

Here’s how an investor could hypothetically make 10% per year from owning shares in Willie Wonka’s chocolate factory.

Montgomery Burns had his eye on Willie Wonka’s Chocolate factory shares, and he decided to buy $1000 worth at $10 per share. After one year, if the share price rose to $10.50, this would amount to a 5% increase in the share price ($10.50 is 5% higher than the $10 Mr. Burns paid).

And if Mr. Burns was given a $50 dividend, we could say that he had earned an additional 5% because a $50 dividend is 5% of his initial $1000 investment.

So if he makes 5% from the share price increase . And he makes an extra 5% dividend, then after one year Montgomery Burns would have made 10% on the shares. Of course, only the 5% dividend would go into his pocket as a “realized” profit. The 5% “profit” from the price appreciation (as the stock rose in value) would only be realized if Mr. Burns sold the Willie Wonka shares.

But Montgomery Burns didn’t become the richest man in Springfield by buying and selling Willie Wonka shares when they fluctuated in price. Studies have shown that, on average, people who trade stocks (buying and selling them) don’t tend to make investment profits as high as investors who do very little (if any) trading.

So Mr. Burns held on to those shares for many years. Sometimes the share price rose and sometimes it fell. But the company kept increasing its profits, so the share price increased over time. And the annual dividends kept a smile on Montgomery Burns’ greedy little lips, as his profits from the share price appreciation coupled with dividends earned him an average return of 10% a year.

But Mr. Burns wasn’t rubbing his bony hands together as gleefully as you might expect. Because at the same time he bought Willie Wonka shares, he bought shares in Homer’s donuts and Lou’s bar. Neither business worked out, so Mr. Burns lost money.

Driving him really crazy, however, was missing out on shares in the joke store company, Bart’s Barf Gags. If Mr. Burns had bought shares in this business, he’d be laughing. Share prices quadruped in just four years.

So how does an investor choose which investments to buy? Here’s a hint. Smart investors don’t choose one stock over another. They buy all of them. There’s an easy way to do that, and the eventual returns put parasitic financial advisors to shame. For further information, check out my postings related to “index funds“.

Compound Interest Calculator

Current Principal: $ 1,000
Annual Addition: $0.00
Years to grow: 90
Interest Rate: 9.92
Compound interest times annually 1
Make additions at the start of each compounding period  
Future Value: $ 4,976,279.61

From the beginning of 1920 until the beginning of 2010, the U.S. stock market (as measured by the Dow Jones Industrial Average) gained 9.92% per year, with 5.72% coming from price appreciation and 4.2% coming from dividends.  Such a return would have turned $1000 into nearly $5 million.  And that includes the stock market crashes of 1929, 1973/74, 1987 and 2008/2009. 







Andrew Hallam

I’m a financial columnist for Canada’s national paper, The Globe and Mail, as well as for AssetBuilder, a financial service firm based in Texas. I’m also the author of Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School (2nd Ed. Wiley 2017) and The Global Expatriate’s Guide To Investing: From Millionaire Teacher to Millionaire Expat (Wiley 2015). My mission is to educate, motivate and inspire people on basic retirement planning and best practices for investing, using evidence-based strategies. I’m happy to comment on your questions. However, please read the Terms of Use, Privacy Policy and the Comments Policy.

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13 Responses

  1. DIY Investor says:

    Nice presentation. Very visual. You may have to follow up with an animated DVD version after the book comes out.

    In the 4th to the last paragraph you may want to mention that not only did Mr. Burns hold the stock over a long period but he also used the dividends to buy more shares.

    I think I'm going to go have a chocolate bar!

  2. DIY investor:

    Thank you! That's an excellent point about the reinvested dividends. I was actually talking to my wife today about having some drawings to accompany the explanations. Some of them could be pretty funny. Not sure about the DVD though!

    I hope you don't mind, but I wrote a post that will come out in a couple of days, mentioning (among other things) how upstanding I think your business model is, and I linked it back to your website. Is that OK?

    Andrew

  3. DIY Investor says:

    I appreciate the mention of my website! Underlying what we do is a passion and in my case I believe strongly that it is very difficult today to retire successfully and to plan for retirement and part of that is the financial services industry taking advantage of people's financial illiteracy by overcharging.

    There are others who believe strongly that the way to go is active management with stock picking, sector picking, and market timing. They argue that it takes a lot of work and their fees are justified.

    I have to say our opinion that low fee, indexed funds is the way to go is backed by mountains of data. ETFs make it easier for investors to do it themselves. It is still not easy – some need guidance to control their emotions!

  4. DIY investor:

    It's true that stock picking takes more work, but I think of it this way.

    You can hire John or Jim to dig a hole in your backyard.

    John charges more by the hour because he uses a pitchfork to dig. Therefore, it's "harder".

    Jim uses a shovel and charges less by the hour because it's "easier"

    Do you pay based on what's "harder" or do you pay based on who can dig you the deepest hole at the lowest cost.

    How many people do you know who can prove to you that over ten, twenty or thirty years, they have beaten (or promise to beat) a diversified basket of indexes?

    Going forward (rather than looking back) I would suggest that anyone promising this is ignorant. Totally ignorant. Their odds are way too slim. And they charge more for that ignorance–or for the hope that their investors are ignorant. Not so cool.

  5. DIY Investor says:

    My reading of the evidence is that 1 out of 10 will probably beat the indexed approach over the long-term but you can't pick the 1. Why people will approach the investing of their retirement funds similar to trying to pick the 1 red ball out 9 blue balls and 1 red ball is surprising.

    The amount to be saved doing it by using low cost indexed funds by the do-it-yourself investor can amount to being able to retire a couple of years early. Talk about having choices!

    You are exactly right – "Not so cool".

  6. Jean says:

    @ Andrew Hallam

    Thanks for making this all so accessible to those of us who are more on the 'newbie' end of the continuum than the experienced investor end. I enjoy reading your blog posts. Your stories, like this one, serve to concretize the rhyme and reason for investing in index funds, for investing wisely (often, as you share your personal life lessons). This Willie W. story is both visual, as DIY investor comments, as well as being comprehensible (I would imagine for youth, the ones that you hope to empower yourself. Your intended audience, by chance?). Your stories and encouragement have me searching for more to read, and I'm finally completing The Millionaire Next Door while I await the full set up of my highly-diversified index fund portfolio! The article you posted earlier from the San Francisco magazine was excellent – long, but well worth the read. Now I'm finally, truly on my path to financial freedom/independence and understanding the rhyme and reason for it all. No more living in financial ignorance for me, as I'm becoming much more financially literate these days! Sincere thanks, Andrew. I look forward to reading more, and wish you well on your new book.

    @ DIY Investor

    If you are reading this, I appreciated the Daniel Solin video clip from the Authors@Google series. All of this has been food for my growing knowledge. Thanks.

  7. Thanks Jean,

    I'm really glad that you're enjoying the journey. It's empowering, isn't it?

    Thanks also to Robert for linking that Solin discussion with Google. Your contributions, Robert, are definitely increasing the quality of my blog and the interactions I'm able to have and learn from!

  8. Hey Andrew,

    If this is how your book is going to read… then I'm highly looking forward to reading it! Clear, concise, easy for anybody to understand… this is just the type of book that should be read by anyone with money to invest.

    If you check out the calculator at . the S&P 500 has turned $1000 into $5,467,180 since 1920. That's even better than the Dow Jones, and also more indicative of the returns of the entire market since more companies are included. I believe expanding to the Wilshire 5000 gives you another % return on top of that.

    The site mentions that "while stocks have certainly beaten inflation over the long run, they've done poorly within the high-inflation periods themselves: try the inflation-adjusted returns for 1916-1918, 1946-1947, and 1973-1981".

    Although taking strategies against high inflation and low confidence in paper assets is a form of market timing, this kind of timing is based on long-term patterns. If you had rebalanced your stock portfolio into gold during the 70s and rebalanced back when gold started to rise stratospherically, you would have greatly improved your returns during those bear years. If you did this with only 20% of your portfolio, you could have doubled your total returns since 1975; the assumption of course is that you get out of the alternative asset before the bubble bursts.

    Then, there is another option which a lot of people benefited from in the 70s as well: Borrow expensive dollars to pay them back with much cheaper dollars. Many people who bought homes for $10,000 to $20,000 at the beginning of the 70s and went for 30-year fixed mortgages ended up benefiting massively from the inflation that followed.

    By the 80s, their homes would be worth $50,000 to $100,000, but the mortgage was the same, and since the rate was 30-year fixed, they didn't have to pay 20% during the worst years (and even if they did, I'm not sure if that would have been enough to compensate the creditors for the inflation). Homeowners came out way ahead, and the savings & loans banks suffered a commensurate loss. No need to avoid a bubble bursting, either, since these gains did not come as a result of speculation into a specific asset; they were the equivalent of shorting the dollar so they came from the depreciation of the dollar in general.

    What do you guys think?

  9. Kevin,

    I'll tell you what I'm really enjoying. The blogging community we have established is really well read. And we're all learning from each other.

    The Gold switch is in line with O'Higgins' philosophy, in "Beating the DOW with bonds". O'Higgins had a pretty mechanical strategy for getting out. If you haven't read the book, Kevin, I think you'll really like it a lot. You might be able to apply this strategy without getting caught in the bursting bubble.

    One thing I have found with finance-related material for the layman, is that so few people understand even the simplest concepts. I bought 80 copies of Bogle's book, The Little Book of Common Sense Investing so I could distribute it freely at work (I know, I sound like an evangelist) but so few people understood the book—and it was the easiest book I could find on money.

    I realized, for my own book, that I have to go one step easier.

    One thing about poorly performing periods is that dollar cost averaging could boost returns by an annual percentage point, as people can load up on stagnating or dropping assets, which eventually rebound.

    And I think there's an even better way of boosting returns without increasing risk or the need for more brainpower. It's described in Michael Edleson's classic book, "Value Averaging" and it adds a further percentage point to historical returns.

    I can describe the philosophy using, say, an international stock index and a U.S. market index. The idea would be to have an equal amount (or a set allocation amount) in each. And you "rebalance" with purchases, putting more money into whatever has done worse in a given month so that after each month's purchase, you have the same amount of money in each.

    According to Edleson, dollar cost averaging would add nearly a percentage point to the scenario you gave with a simple $1000 invested in the S&P 500, in terms of annual returns. Value averaging would have historically added a further percentage point.

    In the scenario you gave with the $1000 turning into $5,467,180 after 90 years, the annual return is 10.03%.

    Adding 2 percentage points to that through value averaging, would have turned that $1000 into $27,548,010.

    Edleson found that it works during all kinds of different time periods. It beats dollar cost averaging nearly every historical 5 year period, and during the vast majority of 1 year periods as well. And it's especially powerful during volatile markets.

    But here's my question. Should I bother mentioning these possibly enhanced methods in my book, http://www.studyfinance.com/jfsd/pdffiles/v13n1/m… or should I keep it simple?

    What do you guys think?

  10. Hey Andrew,

    So on top of dollar cost averaging, you also divert your income based on whichever broad-based index did worse (I don't think you would want to do this with individual stocks; you'd end up putting your money in Enrons).

    So for example, let's say I have Canada at 75% and International at 25%. I allocate $1000 per month. Generally, $750 would go into Canada and $250 would go internationally.

    Let's say then that due to some changes in the market, my International falls and it now looks like Canada at 80% and International at 20%. I would then dump my entire $1000 into International to try to get it back up to 25% instead of splitting the $1000 75/25 as per my desired allocation, or even 80/20 as per my current.

    Let me know if I'm understanding it right or if I got it totally wrong. If dumping the $1000 wasn't enough, then I would go with regular asset portfolio rebalancing, and sell off some Canada in order to buy International, correct?

    If you stick to your Simpsons analogies and present very clear graphs and charts, then I wouldn't leave it out: As per my understanding so far, it's a facet of asset portfolio rebalancing.

  11. P.S. I am going to add "Beating the DOW with bonds" as I have heard you mention it a few times and it certainly does sound interesting. Thanks for the recommendation!

  12. Hey Kevin,

    You're exactly right with the value averaging concept. And I think I'll take your advice and give it a go for the book. It's a pretty simple concept, and of course, it follows the buy low/sell high (if you have to sell at all) concept. And yeah, it deals with funds/indexes, not stocks. Following Enron down with everything would be crazy, wouldn't it?

    Thanks,

    Andrew

  13. Gen says:

    -Smart investors don’t choose one stock over another. They buy all of them.

    Hey Andrew, this statement doesn't seem right to me. I personally think that smart investors would look through a company's annual report and analyse their management (like Warren Buffett does) before buying their shares. If you have only say $10,000 to invest and you buy the shares of 10 different companies, some that appreciate and some that depreciate, the returns will not be as high as if you would have analysed and bought 1 right company that does amazingly well right?

    Let me know what you think 🙂 Interesting article by the way.

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