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FINANCIAL CHRONICLE™ » FINANCIAL CHRONICLE™ » When Stock Prices Go Down, Where Does the Money Go?

When Stock Prices Go Down, Where Does the Money Go?

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notme

notme
Senior Manager - Equity Analytics
Senior Manager - Equity Analytics
From Mike Moffatt, former About.com Guide

[Q:]When stocks take a beating, where does the lost money go?
Example: I bought shares of AOL at $80, but the shares are now worth $15. In whose pocket did my loss of the $65 go?

This leads me to believe that even in a super-down market, somebody is making a lot of money.

[A:] Thanks for your interesting question! It’s one that comes up quite often, usually from someone who just sold a stock for a loss.

When you have a “where does the money go?” type question, a good way of answering it is to construct a simple example. We’ll use four different entities: one company, AOL, and three people named Mert, Becky, and Rachel. AOL has a share in the company that they are willing to sell, and each of our entities have the following amount of money in the bank:

Initial Positions

AOL has $0 (but owns 1 share)
Mert has $200
Rachel has $500
Becky has $1000
Suppose that the following events take place:
Share Sales

AOL has an IPO (initial public offering), and sells one share of stock to Mert for $30.
AOL’s stock goes up, and Mert sells his share to Rachel for $80.
The bubble bursts, AOL’s stock value crashes, and Rachel sells her share to Becky for $15
If we take each transaction one at a time, we can follow where the money goes. We’ll compare each person’s current wealth to the wealth they had when they started. First AOL goes public and sells a share to Mert for $30.
Transaction 1: AOL sells one share to Mert for $30

AOL has $30 (down 1 share, up $30 from initial)
Mert has $170 (up 1 share, down $30 from initial)
Rachel has $500
Becky has $1000
A tech boom occurs and Mert worries it may not last and he sells his share to Rachel for $80.
Transaction 2: Mert sells his share to Rachel for $80

AOL has $30 (down 1 share, up $30 from initial)
Mert has $250 (up $50 from initial)
Rachel has $420 (up 1 share, down $80 from initial)
Becky has $1000
Mert was right and the tech bubble burst. Rachel is worried that AOL may go bankrupt, so she decides to sell her share to Becky for $15.
Final Transaction: Rachel sells her share to Becky for $15

AOL has $30 (down 1 share, up $30 from initial)
Mert has $250 (up $50 from initial)
Rachel has $435 (down $65 from initial)
Becky has $985 (up 1 share, down $15 from initial)
If we’ve done our calculations correctly, the total money lost has to equal the total money gained and the total number of stocks lost has to equal the total number of stocks gained. Mert ($50) and AOL ($30) are collectively up $80, and Rachel ($65) and Becky ($15) are collectively down $80, so no money has entered or left the system. Similarly AOL’s one stock loss is equal to Becky’s one stock gained.
Suppose the true “value” of the share is $15. Then we can figure out each entities net value by adding $15 per share to anyone who has a share, and subtract $15 per share to anyone who is down a share.

Net Value of the Four Entities

AOL has a net value of $15 (up $15 from initial)
Mert has a net value $250 (up $50 from initial)
Rachel has a net value $435 (down $65 from initial)
Becky has a net value $1000 (even)
It has become quite clear where Rachel’s lost $65 has gone: Mert has $50 of it, and AOL has $15 of it. If we change the value of the stock, the total net amount AOL and Becky are up will be equal to $15, so for every dollar the stock goes up, Becky will have a net gain of $1 and AOL will have a net loss of $1. So no money will enter or leave the system when the price changes.
Note that in this situation nobody put more money in the bank from the down market. Mert was the big winner, but he made all his money before the market crashed. After he sold the stock to Rachel, he’d have the same amount of money if the stock went to $15 or if it went to $150.

It is true that AOL’s net value does go up when the stock price goes down, because when the price of the stock plunges, it becomes cheaper for AOL to repurchase the share they sold to Mert. If the stock price goes to $10 and they repurchase the share from Becky, they will be up $20 as they initially sold the share for $30. However, if the stock price goes to $70 and they repurchase the share, they will be down $40. Note that unless they actually make this transaction AOL does not gain or lose any cash from changes in the share price. I've assumed that they do not repurchase the share, so AOL has not gained money from the lower stock price.

Lastly consider Rachel's situation. If Becky decides to sell her share to AOL, from Rachel’s perspective it doesn’t matter what price Becky charges AOL as Rachel will still be down $65 no matter what the price. But unless AOL actually makes this transaction, they're up $30 and down one share, no matter what the market price of that share is.

By constructing an example, we can see where the money went, and see that the guy making all the money made it just before the crash happened.

source-http://economics.about.com

K.Haputantri

K.Haputantri
Co-Admin
Thanks notme for sharing the article.

Expert

Expert
Manager - Equity Analytics
Manager - Equity Analytics
This proves the myth that money is getting wiped off in the market.

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