Block 2: The What
To lay a strong foundation for our investing city (see what we did there), let’s make sure we understand the mechanics of investing and business and how it all works together…
When an ambitious entrepreneur dreams up a business idea, she needs money to make it happen. She pitches the idea to investors (probably friends and family) and, in return for their money, the investors usually get an ownership stake in the business. Just like Shark Tank! By sacrificing the right to enjoy their money now, the investors require compensation in the future. This is the essence of investing!
When you put money in your savings account, the interest you receive is your compensation (or return, the money that returns to you as an investor). When it comes to investing in businesses though, return is not guaranteed. This means, as an investor in businesses, you take on risk. There is a “risk” that you may not even get your initial investment back if the business fails.
On the other hand, in that savings account, you assume basically no risk, so you settle on a lower return. A higher risk means there is a higher probability you can lose part or all of your investment; so to compensate for that risk, you demand a higher return. For instance, you are going to demand much more money from your friend if he dares you to jump in the Arctic Ocean compared to jumping into Waikiki waters. The risk (of death or maybe just discomfort) of jumping into the Arctic waters is much higher therefore you demand more compensation.
Like in Shark Tank, the sharks will demand a higher ownership stake for a business that looks “risky” to them. If there is a higher probability the business won’t work out, they want to make sure they are getting their money’s worth if it does.
In summary, we covered that investors are seeking return for sacrificing the right to enjoy their money now. We also explored the risk vs. return relationship that is at the heart of investing. A higher probability of failure means investors want to be compensated enough to make that leap of faith. Let’s see what is next…