Friday, October 10, 2008

When the markets go down, where does the money go?

A reader recently asked a great question:
Where do the missing billions [now trillions] go?  When the stock market goes down does that money just disappear or does someone somewhere gain as a result?
Unfortunately, wealth does not follow Newton's Second Law of Thermodynamics.  It can be both created and destroyed.  When the stock market goes down wealth disappears.

Consider the example of a kid with $5 and a baseball card that he bought for $1.  If the other kids in the neighborhood think that the player on his card is the coolest player in the league and offer to buy the card for ten bucks, how much money does this kid have?  Unless he sells the card, all he's got is five dollars.  He also has a baseball card that even though he only paid for one dollar for it is worth ten dollars.  So, his net worth has gone up by nine dollars because the value of the baseball card increased.  However, the baseball card isn't money (and stocks aren't money).  Only money is money.

Now as the season goes on, the other kids start to think that this player quite as cool as they thought he was.  If Johnny, who owns the card, wants to sell it now all he could get would be two dollars.  Therefore, his net worth has just decreased by eight dollars.  That eight dollars has just plain disappeared.  If Johnny agrees that the card in only worth one dollar then he might sell the card.  However, if he thinks that everyone else is wrong about this player and given time they will come around to like him, Johnny might decide to hold onto the card in order to sell it for a better price later.  Johnny will not actually realize any financial gains or losses until he sells the card.

As the value of Johnny's card went up and down, his net worth increased and decreased.  That wealth was first created and then destroyed.  When Johnny's net worth went down nobody else's wealth went up as a result.  Stocks work the same way as that baseball card.

When you buy a share of stock, you are buying partial ownership of a company.  The price of stocks is set in an auction type market.  People value stocks based on the expectation of the future cash that the company will earn.  If lots of people believe that a company will generate lots of cash they will all buy stock in this company.  As they compete with each other in the market to buy these shares they will drive up the price.  If as time goes on, the company fails to earn as much money as expected, the perceived value of the company will fall.  As the perceived value of the company falls, fewer people will be interested in buying the stock and the price of the stock will fall as well.  If stocks that you own lose value, it is because the perceived value of the underlying company has decreased.  The value of your portfolio then falls.  That wealth that you had yesterday has been destroyed today.

Any gains or losses from your stock investments are called paper gains or losses for as long as you actually own the investment.  Until you sell the investment and convert it back to real money, all your gains and losses are just numbers on a sheet of paper and can change at any moment.  They are not real money until you sell.

On a side note, it is possible to bet against the market by "short selling" a stock.  If you do this, you will make money when if the market goes down and lose money if it goes up.  However, the total amount of money lost by investors as a stock falls is not connected to money made by anyone who might be shorting that stock.

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