How Can the Stock Market “Erase” Trillions of Dollars?
Dan Nastou, CFA
Whenever the stock market tumbles, we see news headlines like “Stock market erases X billion/trillion dollars of value in just one month” or something to that effect.
But how can money simply be erased from the market? Doesn’t someone need to walk away with it? Some savvy investor who timed the market perfectly and profited?
Well, simply put, no. Market valuations depend on the perceptions of investors and the prices set by current buyers and sellers at any given moment, which are always changing. This means paper wealth, represented by those valuations, is constantly being created and destroyed.
This may seem a little strange at first glance, so let’s dive in with an example.
Owning a business with Bill and Jill
Suppose you and two of your friends, Bill and Jill, own a business, and you three are the only owners. Let’s say you each own 100 shares of stock in the business, which means there are 300 shares in total, representing the entire business.
Now, let’s say business is booming and you decide you want to own a larger share of the company. You approach Jill about buying some of her shares, but she says she’s not selling at any price. So you approach Bill, and he’s willing to part with a few shares for what you both decide is a reasonable price, let’s say $1,000 per share.
At the moment, the entire business would be valued at $300,000 (300 total shares, each valued at $1,000). Keep in mind, that doesn’t mean you all own $300,000 in cash, that’s simply what the business is currently valued at based on the most recent transaction price.
Bill wants ‘em back
Suppose a few months go by and the business has grown even more, and Bill wants to buy his shares back. Jill is still not willing to sell any of hers and you now think the business should be worth even more than it was. So Bill has to offer you $1,200 per share to entice you to sell.
At the current price, the total business is now worth $360,000. The “market value” has grown by 20% since you last transacted. You’ve profited by selling Bill’s shares back to him at a higher price, and your original shares have increased in value – way to go!
But nothing lasts forever
Now let’s say six more months have passed and the economy has hit a rough patch. Business is no longer booming and you’re all starting to get a little concerned about its prospects.
And let’s say you are now in the process of buying a house and need to sell your shares to raise money for the down payment.
You go to Bill, but he’s run into financial troubles of his own and can not buy any shares (sorry Bill). Jill is willing to buy from you, but can only afford to pay $600 per share. Reluctantly you agree to sell since you need the money now.
At this point, the market value of the business has fallen to $180,000 (3,000 shares each valued at $600), a fall of 50% since the last valuation. But no one has “walked away with the money”. Yes, you cashed out $60,000 (you sold 100 shares for $600 each). But that’s just because Jill cashed that much in to pay you. Not to mention, your total net worth was considerably higher six months ago when you owned 100 shares valued at $120,000.
The fact is, the total market value of the business can change quite suddenly based on the views of the buyers and sellers (and their ability to pay). And yet no one “took the money out”.
Sure, but what about the REAL world?
Now of course this is a simplified example. But the concept remains the same in the real world.
Prices for financial assets are set by the current buyers and sellers – who are transacting now. And those prices impact the valuations for all holders.
So if the market of buyers dries up for a particular stock or asset, the market value can fall substantially without anyone really profiting. And if it happens on a large enough scale, then billions or even trillions of dollars of valuation can “disappear”.
It may seem strange to think of the valuation evaporating into thin air like that, but it can, just as it increased when prices were on the rise. Ultimately, prices, and therefore valuations, depend greatly on the perceptions of the buyers and sellers in the market at any given time. And those perceptions can sometimes change quickly.
So for us investors, it’s important to not fixate too closely on the day-to-day price movements. Unless you plan on selling your investments tomorrow, these are somewhat meaningless fluctuations. What really matters is the long-term wealth creation that results from holding your investments over years and decades. And that, well, takes time.
Interested in more?
