The article demonstrates why stocks and bonds are created.
A Business Is Created
Amrut is a farmer, and he is interested in starting up an apple stand for the tourists who pass his place. Since Amrut has fairly good credit, he got a business loan to cover the costs of set up, and he now has the ideal land for apple growing. Unfortunately Amrut only set aside enough money for getting his land in shape. He forgot all about buying seeds. By a stroke of luck, he finds a store that will sell him a magic high-growth, high-yield seed for Rs.100, but Jack only has Rs.50 left.
The Initial Public Offering to Raise Capital for Growth
Our clever farmer goes to five of his closest friends (you're included) and asks if they'll each give him Rs.10 to help his business. However, Amrut doesn't know if he can take it in the form of a loan because he may not be able to pay it back if the seed doesn't turn a profit. No worries: Amrut promises everyone they'll receive a percentage of the tree's apples that is equal to the percentage they gave. In other words, Amrut has given his friends a share in his tree. They agree and the seed is in the ground.
The Distinction Between Being a Partner and Being a Shareholder
This tree, being magic and all, grows rapidly. In the first month, it is five feet tall and there are two apples. Amrut keeps one apple because he owns 50% of the business's product, which he paid for with the Rs.50 he put in for the seed. He cuts the other one into five pieces, each of which goes to each of his investors, who can sell or eat it. The investors have a quick meeting and decide they'd rather have him sell their portion of the product and give them a percentage of the profit. So Amrut makes up little papers saying, "Amrut's Apple Company: you have one share guaranteeing you 10% (10/100) of the profits."
Trading Occurs in Amrut's Undervalued Stock
So this tree really takes off now - the magic is coursing through the wood and it grows to 10 feet tall! There are 20 apples and he sells them all for Rs.10 a piece, keeping Rs.100 for himself and giving his friends Rs.20 each. He uses his Rs.100 to buy another seed and plants it. Pretty soon, he has two trees producing 40 apples and earning Rs.400 a month.
Some of his neighbors want in on the deal Amrut gave his friends, and Pravin, Jack's first investor, is interested in selling his 10% of Amrut's Apple Company. Jaya, Amrut's neighbor, wants to buy it and she offers Pravin the Rs.10 that he originally paid. However, Pravin is not stupid: he realizes that this share is producing Rs.40 a month and Amrut is about to buy another seed. So Pravin asks for Rs.40 and Jaya snaps up the share, which pays for itself immediately.
A Bit of a Bubble Forms
The other original shareholders see how much Pravin got and want to sell too, and the other neighbors notice how quickly Jaya's investment paid off so they really want to buy in. The offers steadily climb until Amrut's shares are being bought for over Rs.100 a piece - more than Amrut's trees are producing in a month. Only one original shareholder, Bharti, is still in there and holding out on offers like Rs.120 because she is still getting a regular payment that is pure profit for her. Suddenly, Amrut's trees (four in total) are ravaged by aphids (plant eating green flies). The entire month's production is ruined and several shareholders are wondering if they can pay rent since they used their savings to buy shares.
The Bubble Bursts
The shareholders that need the money sell to Bharti at a discount (Rs.40), and then the other shareholders notice, all of a sudden, that their Rs.100 shares are worth Rs.40. This is very disconcerting. The remaining shareholders offer their shares to Bharti, but she says she's quite content with three shares. The other shareholders are desperate now, so when you (one of the investor) offer them Rs.20 a piece for the shares, they take their losses and get out.
Meanwhile, the main drive of Amrut's business hasn't changed: people still want apples. He needs to get rid of these pesky aphids and he needs the money to buy insecticide.
Amrut Issues a Bond
Amrut is not too keen on issuing more stock after the fiasco with his neighbors, so he decides to go for a loan instead. Unfortunately, Amrut used up his credit with the land preparation so he is once again looking for divine inspiration. He's looking at his equipment to see what he can sell and what he can't, and then it hits him: he'll try to sell his apple crates without actually selling them. The crates are useless without aphid-free product to fill them, but as soon as the aphids are gone he'll need them back.
So Amrut calls up Jaya (in hopes of making amends) and offers her a deal, "Jaya, my good friend, I have an offer for you. I'll sell you my apple crates, which are worth Rs.100 total, for a mere Rs.60 and then buy them back next week for the full Rs.100." Jaya thinks about this and sees that in the worst case scenario, she can just sell the crates… sounds good. And a deal is made.
"But Jaya," Amrut adds, "I don't want to run my crates down there and pick them up again. Can I just write up a piece of paper? It'll save my back."
"I don't know - can we call it a promissory note?" Jaya asks enthusiastically.
"Sure can, but I was thinking more of calling it a bond or a certificate," says Amrut.
And lo and behold, Amrut eliminates the aphids, pays Jaya back, and turns a healthy profit that month and every month thereafter.
What Did We Learn?
This story will not explain everything about investing in stocks, but it does highlight one very important point: the price of Amrut's stock followed investors' opinion of the stock's value rather than just the performance of Amrut's company. Because the stock market is an auction, there is no set price for a certain stock, there is a concept that derails most people's trains of thought: the price paid for a stock is what it's "worth" until a lower or higher price is offered.
This fluctuation of worth is good and bad for investors because it allows for profit (when you buy an undervalued stock) but also makes losses possible (when you pay too much for a stock)
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