I was reading the newspaper the other day, particularly the stock market section, when the 12-year-old son of a friend asked me what the table of numbers on the page was.

I said that it’s the stock market prices of Philippine companies.

He obviously got curious because he then asked me to explain what the stock market is and why it’s so important that newspapers publish that table everyday.

He’s a smart kid and I know he’d appreciate it if I explained the stock market further to him, but I had to do it as simple as I could. So here’s how it went:

“You know my internet cafe, right?” I began.

“Yeah, that’s your business,” he replied.

“Who owns it?” I asked.

“You.”

“Yes, me and a couple of other people. We’re a company – a private corporation,” I answered. “It’s a private corporation because the owners of the business is limited to only a small group of people.”

“Now some businesses, very big businesses like Jollibee – they’re public companies,” I continued. “That means it is owned by a whole lot of people.”

( Learn the different types of business structures here. )

“How come there are private companies and public companies?” he inquired.

“All businesses usually start out as a private company. Then after a few years, they might want to grow and expand – like put more branches or develop more products. And sometimes, the best way to do that is to sell a part of the company to other people,” I explained.

“So let’s say I want to put a new branch of my internet cafe but I don’t have enough money to do so,” I said. “Then I can perhaps ask your father to invest in the business.”

“Invest?” he was a bit confused.

“Yes, that means I will ask your father to buy a part of the business. And when he does and I receive his money, I can then use that to put up a new branch. But this time, when the business earns money, we three, the original owners of the company, would no longer get all the profit because we have to give your father his share of the income.”

“Because he is already one of the owners of the company,” he says.

( Read a beginner’s guide to investing here. )

“That’s right,” I concurred. “Now what if our plan is to put up hundreds of branches all over the country – your father’s money will not be enough to do that. We need more people to invest in the business. And one of the ways to do that is to make our private company, public. Which means we will be selling part ownership of our business to the public and anyone who wants to become an owner can buy a share.”

“So when that happens,” he concludes. “Your private company now becomes a public company.”

“Yes, that’s right,” I agreed. “And that’s where the stock market comes in. The stock market is a place where you can buy shares of public companies and become a part owner of those businesses.”

“And make money when the business earns, right?” he quipped.

“Yeah, you can say that. But not all public companies give dividends, that’s what you call the income you get as an owner of a public company,” I replied.

“So why would you buy a share from a company if they won’t give you a portion of their profit?” he inquired.

“That’s a very good question!” I exclaimed.

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I’ll give the rest of the conversation in my next post. Be sure to catch part 2 when it comes out by simply subscribing to Ready To Be Rich.

Update: Explaining The Stock Market To A 12-Year-Old Part 2

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Photo credit: Bearman2007