My holiday "Advice for Kids" column typically offers grist for the mill designed to stimulate a family discussion around saving and managing money. This year, some regular readers over the years may find the usual advice like "stay out of Starbucks and invest the $2 per day" a little tedious. For them, I'll offer the fundamentals that explain how Facebook's Mark Zuckerberg can suddenly be worth close to $15 billion -- and how it could just as well happen to you.
But first, I'll offer a touch of the tedious just to satisfy the dictates of good financial advice. For starters, saving just $100 per month for the next 40 years will accumulate to $500,000 assuming average annual stock market returns of 10 percent per year. The difference between the $48,000 you gave up ($1,200 per year times 40) and the $500,000 in your account is called "the magic of compound interest."
Money earning 10 percent doubles every 7.2 years. All you need to do to accomplish these results is to invest in a so-called 500 index fund that invests in the 500 largest companies. Want more money sooner? Saving $250 per month will compound to about $50,000 in 10 years, and $500 per month will pile up to $100,000 in that same short time. See how easy it is to develop the smug sense of satisfaction that comes with achieving some financial security?
As for housing, one of the best investments anyone can make once they settle down is to buy a home or condominium. Suddenly what was rent now becomes interest and property taxes that are tax deductible.
To find out how valuable this deduction can be, take a look at your tax tables and calculate how much you pay in total state and federal taxes on the last few dollars of your income. For most single people, the last dollar is taxed at more than 30 percent. You can think of this, in effect, as the amount that state and federal governments are subsidizing your tax-deductible 401(k) or mortgage payments. Ask your parents to explain this if you're unclear on the concept.
Let's move right along to Zuckerberg and Facebook.
Huge wealth can be created out of what may seem to be thin air, and here's how: Take a handful of employees working for what had been a sweat-equity startup whose people survived on pizza and by sleeping in the wastebaskets at night. If their better mousetrap gets some traction and they convince a venture capitalist to invest $10 million in return for a 50 percent interest, the other half owned by the founders suddenly also is worth $10 million.
A few years later, maybe 10 percent of the company is sold for $100 million, which makes the owners of the other 90 percent -- the founders and that venture capital firm -- collectively worth $900 million.
It gets better. Taking the company public introduces "the greater fool theory" (no matter what I pay today, someone else will pay more tomorrow) thanks to the participation of unsophisticated stockholders. Their frenzied buying creates an inflated multiplier that sends the value of all shares right off the charts.
But get this: When it goes public, only a relatively small percentage of the company is sold. In this example, perhaps 25 percent of the company is sold to the public for stock in an IPO priced at $1 billion. This makes the other 75 percent, still owned by founders and two venture capital firms, worth $3 billion.
The fundamental idea here is a stock valuation mechanism referred to as "marked-to-market." It means that all outstanding stock shares in a company are valued based on the share price of what is being bought and sold at a given time. In the above example, we saw how 10 percent selling for $100 million made the whole company effectively worth $1 billion.
For public companies, only a miniscule fraction of their total stock actually trades on Wall Street on a given day -- far less than 1 percent. But the sales price of that miniscule percentage sets the price for all the remaining stock in the company literally from second to second during the day. This changing share price determines the value of shares sold in the stock market as well as the shares still held by founders and venture capital firms.
There's a common phrase, "by the time a company goes public, the real money has already been made." Don't believe it. The rest of us won't get rich overnight, but we can get there slowly over time with discipline and the knowledge of investment basics. Just do it.
Stephen Butler is CEO of Pension Dynamics. Contact him at email@example.com or 925-956-0505, ext. 228.