Imagine you own a goose that lays golden eggs. It lays one golden egg per year. How much would you sell it for? Probably not one golden egg, but definitely you’d sell if for a million gold eggs. You’d probably settle for maybe 5? 10? 15? Something like that.
Suppose the goose only lays one egg per year now (or none at all!) but it’s still young and most people expect it to start laying four or five or even ten or twenty eggs per year in a few years from now. It’s impossible to tell for sure how many it’ll lay over its life, or when that will happen, or if it will happen at all. NOW how much do you sell it for?
That’s the stock market.
A bunch of investors think a bunch of gooses will start laying a ton more golden eggs soon, and they’re willing to pay big bucks now in exchange for the possibility of that in the future. This isn’t a pyramid scheme or a zero sum game or anything like that. It’s just a prediction of the future which may or may not be correct, and only time will tell.
I don’t want to pay for the full goose right now, I just want to pay for the right to buy the goose later, at a price that’s fixed now. I’ll decide later if I actually want to buy the goose or not.
Alternatively, I’m not sure how much my goose will continue to lay in the future, I’d like to pay for insurance to guarantee me a fixed price to sell the goose later if I want to.
What about the stock market? They seem to be pricing companies way higher than they are worth.
Imagine you own a goose that lays golden eggs. It lays one golden egg per year. How much would you sell it for? Probably not one golden egg, but definitely you’d sell if for a million gold eggs. You’d probably settle for maybe 5? 10? 15? Something like that.
Suppose the goose only lays one egg per year now (or none at all!) but it’s still young and most people expect it to start laying four or five or even ten or twenty eggs per year in a few years from now. It’s impossible to tell for sure how many it’ll lay over its life, or when that will happen, or if it will happen at all. NOW how much do you sell it for?
That’s the stock market.
A bunch of investors think a bunch of gooses will start laying a ton more golden eggs soon, and they’re willing to pay big bucks now in exchange for the possibility of that in the future. This isn’t a pyramid scheme or a zero sum game or anything like that. It’s just a prediction of the future which may or may not be correct, and only time will tell.
That’s the description of the very basics of the stock market.
Now do the derivatives, and let’s see why it’s gone to hell.
I don’t want to pay for the full goose right now, I just want to pay for the right to buy the goose later, at a price that’s fixed now. I’ll decide later if I actually want to buy the goose or not.
Alternatively, I’m not sure how much my goose will continue to lay in the future, I’d like to pay for insurance to guarantee me a fixed price to sell the goose later if I want to.