This post is a ‘sneak peak’ at my 2011 book! 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.