Stocks and Bonds Explained Using Lemonade Stands

A little while ago, a friend asked me what the difference between a stock and a bond is.

He understood that every individual should invest in both because both can be an important part of building wealth… but didn’t understand more than that.

Accordingly, he asked me, “the finance guy.”

Truth be told, I don’t think I did a good job explaining in simple terms.

So, to my unnamed friend, here’s a better answer using something we can all identify with… lemonade stands.

Let’s say you are thinking of starting a lemonade stand, but don’t have the money.

So, you then go to your friends and family and ask them for money in return for shares of your lemonade stand. You expect to make a profit so they’ll share in that as part the business, as well.

Specifically, you ask for $5 per share of the stand, and end up collecting from 10 people. You now have $50 to work with and each of your investors “own” 1/10th of the lemonade stand.

Fast forward a year, and your lemonade stand is making a killing. You’ve got customers lining up around the block and are raking in the big bucks. Naturally, someone else wants to own part of your company and is now willing to pay $10 to own the same share you sold for $5 only 12 months ago.

Why does this happen?

Why are they willing to pay $10 for something that used to be $5?

This happens because, as a by-product of owning part of your lemonade stand, the investors are not just buying a part of the company in the physical sense but also a proportionate share of anticipated profits which you’ll distribute every so often.

For example, if you succeed in producing $100 in profits and have decided ahead of time to distribute 1% to each investor, each investor would get $1 when it comes time to distribute the earnings. (This is a gross oversimplification because setting so-called “payout ratios” can be pretty complicated in real life — but the concept is what’s important.)

This is why people buy stock… so they can get in on the action as your business grows.

We can also note that, because someone was willing to pay $10 for that one share, every other share is now worth $10 as well. So, while you didn’t necessarily change anything or get new funding, your lemonade stand is now worth $100 because business is good and because each share you sold when you started is now worth more.

However, you also have to remember that this relationship can go in the other direction. If your sales go down for whatever reason (maybe it’s a strong competitor selling bubble tea, your neighbor’s kid is undercutting your prices, or the weather is bad) people won’t pay as much for shares in your lemonade stand.

Now let’s talk about bonds.

Let’s return to our lemonade stand.

Let’s say your business is really doing well, and you’d like to expand around town by building a bunch of stands that will be placed in different locations. The total bill will be around $500.

You could raise more money by selling additional “shares” to other investors but — like many profitable business owners — you decide you’d rather keep most of the profits. (Because remember, you’d have to distribute profits to any shareholders.)

At this point, there are two options.

First, you ask your mom if she’s willing to lend you $500 — to which she replies “no”.

Unfazed, you then decide to break up that $500 into smaller $100 chunks and ask your friends to individually lend you the money.

To sweeten the deal, you promise to return the money in 3 years while also paying 5% annually in exchange for the risk they’re taking by loaning you the money.

Loosely put, you’re issuing bonds which by any other name are simply fancy IOU’s with a finite expiration date and predetermined interest rate or cost associated with the loan.

Well trusted businesses with solid track records and reputable leaders that are likely to be profitable can borrow for lower rates… say 5%. But, unproven businesses run by dubious leaders with terrible sales history may have to pay considerably more — even double or 10% for purposes of our example.

There’s a catch, though.

Because you’ve borrowed money from your friends, you do have to pay it back plus interest on schedule whether your lemonade stand is making money or not.

Let’s wrap up.

When you buy stock, you are investing in a company and, in exchange, receive a proportionate portion of the profits plus the appreciation in value associated with the business itself.

When you buy bonds, you are lending a company money and, in exchange, receive a promise to return that money plus interest over a specific time frame.

They’ve both got pluses and minuses in today’s financial markets, but we’ll talk about those another day.

The important thing today is to help you understand the differences between stocks and bonds.

So, there you have it.

If you enjoyed reading it and would like to see more, I’m planning to continue my “lemonade stand” series in the future using your questions as a platform to talk about more complicated financial stuff. Message me or leave a comment with any concepts you’d like to understand better, and hopefully, this article becomes part 1 of a much larger series.

Kuni