When Stock Prices Drop, Where Is the Money?‌

When Stock Prices Drop, Where Is the Money?‌

TABLE OF CONTENTS

Disappearing Money

Implicit and Explicit Value

Disappearing Trick Revealed

Have you ever wondered what happened to your socks when you put them into the dryer and then never saw them again? It's an unexplained mystery that may never have an answer. Many people feel the same way when they suddenly find that their brokerage account balance has taken a nosedive. Where did that money go?

Fortunately, money that is gained or lost on a stock doesn't just disappear. Read to find out what happens to it and what causes it.

KEY TAKEAWAYS

When a stock tumbles and an investor loses money, the money doesn't get redistributed to someone else.

Essentially, it has disappeared into thin air, reflecting dwindling investor interest and a decline in investor perception of the stock.

That's because stock prices are determined by supply and demand and investor perception of value and viability.

Disappearing Money

Before we get to how money disappears, it is important to understand that regardless of whether the market is rising–called a bull market–or falling–called a bear market–supply and demand drive the price of stocks. And it's the fluctuations in stock prices that determines whether you make money or lose it.

Buy and Sell Trades

If you purchase a stock for $10 and sell it for only $5, you will lose $5 per share. It may feel like that money must go to someone else, but that isn't exactly true. It doesn't go to the person who buys the stock from you.

For example, let's say you were thinking of buying a stock at $15, and before you decide to buy it, the stock falls to $10 per share. You decide to purchase at $10, but you didn't gain the $5 depreciation in the stock price. Instead, you got the stock at the current market value of $10 per share. In your mind, you saved $5, but you didn't actually earn a $5 profit. However, if the stock rises from $10 back to $15, you have a $5 gain, but it has to move back higher for you to gain the $5 per share.

The same is true if you're holding a stock and the price drops, leading you to sell it for a loss. The person buying it at that lower price–the price you sold it for–doesn't necessarily profit from your loss and must wait for the stock to rise before making a profit.

The company that issued the stock doesn't get the money from your declining stock price either.

Short Selling

There are investors who place trades with a broker to sell a stock at a perceived high price with the expectation that it'll decline. These are called short-selling trades. If the stock price falls, the short seller profits by buying the stock at the lower price–closing out the trade. The net difference between the sale and buy prices is settled with the broker. Although short-sellers are profiting from a declining price, they're not taking your money when you lose on a stock sale. Instead, they're doing independent transactions with the market and have just as much of a chance to lose or be wrong on their trade as investors who own the stock.

In other words, short-sellers profit on price declines, but it's a separate transaction from bullish investors who bought the stock and are losing money because the price is declining.

So the question remains: Where did the money go?

Implicit and Explicit Value

The most straightforward answer to this question is that it actually disappeared into thin air, along with the decrease in demand for the stock, or, more specifically, the decrease in investors' favorable perception of it.

But this capacity of money to dissolve into the unknown demonstrates the complex and somewhat contradictory nature of money. Yes, money is a teaser—at once intangible, flirting with our dreams and fantasies, and concrete, the thing with which we obtain our daily bread. More precisely, this duplicity of money represents the two parts that make up a stock's market value: the implicit and explicit value.

Implicit Value

On the one hand, value can be created or dissolved with the change in a stock's implicit value, which is determined by the personal perceptions and research of investors and analysts. For example, a pharmaceutical company with the rights to the patent for the cure for cancer may have a much higher implicit value than that of a corner store.

Depending on investors' perceptions and expectations for the stock, implicit value is based on revenues and earnings forecasts. If the implicit value undergoes a change—which, really, is generated by abstract things like faith and emotion—the stock price follows. A decrease in implicit value, for instance, leaves the owners of the stock with a loss because their asset is now worth less than its original price. Again, no one else necessarily received the money; it has been lost to investors' perceptions.

Explicit Value

Now that we've covered the somewhat "unreal" characteristic of money, we cannot ignore how money also represents explicit value, which is the concrete value of a company. Referred to as the accounting value (or sometimes book value), the explicit value is calculated by adding up all assets and subtracting liabilities. So, this represents the amount of money that would be left over if a company were to sell all of its assets at fair market value and then pay off all of the liabilities, such as bills and debts.

However, without explicit value, the implicit value of the company would not exist. Investors' interpretation of how well a company will make use of its explicit value is the force behind the company's implicit value.

A stock's implicit value is determined by the perceptions of analysts and investors, while the explicit value is determined by its actual worth, the company's assets minus its liabilities.

Disappearing Trick Revealed

For example, let's say Cisco Systems Inc. (CSCO) had 5.81 billion shares outstanding, which means that if the value of the shares dropped by $1, it would be the equivalent to losing more than $5.81 billion in (implicit) value. Because CSCO has many billions of dollars in concrete assets, we know that the change occurs not in explicit value, so the idea of money disappearing into thin air ironically becomes much more tangible.

In essence, what's happening is that investors, analysts, and market professionals are declaring that their projections for the company have narrowed. Investors are, therefore, not willing to pay as much for the stock as they were before.

When investor perception of a stock diminishes, so does the demand for the stock, and, in turn, the price.

So faith and expectations can translate into cold hard cash, but only because of something very real: the capacity of a company to create something, whether it is a product people can use or a service people need. The better a company is at creating something, the higher the company's earnings will be, and the more faith investors will have in the company.

In a bull market, there is an overall positive perception of the market's ability to keep producing and creating. Because this perception would not exist were it not for some evidence that something is being or will be created, everyone in a bull market can be making money. Of course, the exact opposite can happen in a bear market.

In other words, think of the stock market as a huge vehicle for wealth creation and destruction. No one really knows why socks go into the dryer and never come out, but next time you're wondering where that stock price came from or went to, at least you can chalk it up to market perception.