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Understanding the psychology of secondary markets.

May 5, 2011

I created the following analogy to protect you as an investor from the pitfalls of secondary markets. Rule #1: Sex, power and money will ruin more lives than anything else. Rule #2: Friends, relatives, employees and business associates will turn into enemies if you don’t have the skills to handle complicated sex, power or money matters in your relationships.

Secondary markets are complicated: The analogy: You, David and George work hard with/for Mark Zuckerberg and others to try to make Facebook a great social network company. Mark pays you guys with pre-IPO shares because the new private company has little income and he wants you to work harder for a piece of the action. Two years later Facebook is used by more people than the other social network private companies. Facebook is making some dough from advertising. By now you are really broke. You can hardly pay your rent, but you own 10,000 pre-IPO shares. David, whose father is an investor, borrows money from his dad and offers you and George $25 per share for your combined 20,000 pre-IPO Facebook shares. You grab the $250,000.00 cash and run.

Two years later Facebook is “hot.” Like with the “hot” mortgage market before it collapsed in 2008, new companies pop up like mushrooms after rain whose sole business is buying Facebook pre-IPO shares from poor employees. David sells his 20,000 shares for $50 a piece to one of these companies and makes a “cool” half a million profit. All three Facebook employees get fired by Zuckerberg who worry about legal matters, and start new companies that “package” pre-IPO shares of Facebook, Twitter, and other private companies and sell them to the highest bidders. Litigations about legal issues such as what is liquid or illiquid assets, should the FTC allow more than 500 shareholders holding pre-IPO shares, will the new industry hurt real IPOs and the liquidity of the market, and so on. Smart investors decide to unload their pre-IPO shares in the secondary market and become rich, but the majority of shareholders holding pre-IPO shares they paid $75 each – can’t. David and his father start a new company that offers $25 per share to these one million people who own shares they bought for $75 and can’t sell. They sell them to David and recover 33% of their investment.

Two years later the legal issues about secondary market shenanigans is resolved in federal court, just before Facebook goes public at an IPO of $100.00 in 2012 or 2013. David becomes the second youngest billionaire after Mark, you and George become millionaires, and a million investors lick their wounds and decide to put whatever they had left – in Mutual Funds. New mutual funds companies pop up and the economy expands (75% of all Americans today invest in MFs). What is the moral of the story? Stay away from secondary markets, they are too complicated and greedy, unless you are a brilliant investor and have nerves of steel. I am not. I waited for Google to go public IPO, bought shares at $133 per share and sold at $500. I am not brilliant like David and I don’t have nerves of steel like David – just patience and I love the Law of Parsimony. I am “cool.”

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