When Stock Prices Drop, Where Does Your Money Go?
“Invest in the stock market!”
Such is the urgent cry of most every financial expert and self-made millionaire. Then they go into further detail and you realize that it’s basically impossible to invest in the stock market without taking on risk. It’s overwhelmingly likely that if you maintain a diverse investment portfolio for the long haul, you’ll come out on top, but that doesn’t mean you won’t suffer losses along the way.
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One major question that may pop up for new investors, in particular, is: When a stock you’ve invested in drops in value, where does your investment go? In other words, what the heck happened to that money you handed over in the strategic hope of seeing it grow? Has it disappeared?
We do not have a simple answer for you, because this is, interestingly, not a simple question, but we do have illuminating insights. Let’s dig in.
Wealth Is Destroyed — But Not Forever
We do have one somewhat simple (or, at least, blunt) answer about what happens when stock prices fall: Wealth is destroyed.
“That is, the collective value of wealth drops,” said Robert Johnson, PhD, CFA, CAIA, chairman and CEO at Economic Index Associates. “The stock markets and housing markets are what economists refer to as a positive sum game — that is, one in which wealth can be increased (or decreased, at times).”
Now, hearing that “wealth is destroyed” may be anxiety-inducing, but before you go racing to pull out your stock investments when you see devaluation, understand the benefits of a long-haul approach, about which you should be optimistic.
“Certainly, over the long-term, investing in the stock market is a positive-sum game,” Johnson said. “That is, over the long run the value of stocks, both individually and collectively, generally rises. According to data compiled by Duff & Phelps, from 1926 through 2022 large cap stocks (think S&P 500) returned 10.1% annually, on average.”
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Bubbles Are Created That Can Hurt Short-Term Investors
Dr. Tenpao Lee, professor of economics at Niagara University, explained to GOBankingRates that when stock prices go up, bubbles are created. Through this, long-term investors see paper gains.
“In the same token, when stock prices go down, bubbles are broken or shrunk, and long-term investors would have disappeared paper gains or even paper losses,” Lee said. “In other words, the money did not exist or disappear for long-term investors if you did not make any transactions. However, for short-term investors, when stock prices go up or down, the money would be transferred among them as a zero-sum game, i.e. your losses would be others’ gains, and vice versa.”
Your Loss Means Another’s Gain
Johnson explained this zero-sum game and how it operates.
“Both the short- and long-term, the currency markets and options markets are examples of zero-sum games,” Johnson said. “In a zero-sum game, there is a finite quantity of resources where one player’s loss equals another player’s gain. In the currency market, for instance, when the U.S. dollar strengthens versus the Yen, those holding U.S. dollar positions win and those holding Yen positions lose an equal and opposite amount. In the options markets when one owns an option that rises in value, someone loses an equal and opposite amount.”
It Ties Back to the Shareholder Who Sold You the Shares
Generally, when you buy a share in a public company, you’re actually buying a share from a shareholder within the company. When their stock drops, they take a hit. Or, maybe, they come out on top. It depends.
“So, your $1,000 went to that shareholder in exchange for the 100 shares you purchased from them, which goes through an intermediary such as an exchange or market maker,” said Don Montanaro, president at Firstrade Securities Inc. “Maybe they previously bought the shares for $5 or $7 or $12 per share. So maybe they realized a gain, or maybe a loss, when they sold to you.”
Think of a Stamp Collector
One way to think about how the stock market works is to imagine a stamp collector. They’re not really trading or holding money anymore, they’re holding an investment that may alter in value.
“When they buy a stamp, they trade currency for an item — a collectible stamp,” said Ken Robinson, JD, CFP, founder and senior advisor at Practical Financial Planning. “That stamp has a specific resale value on any given day. But they know it isn’t the same as having money — if they want money, they’re going to have to trade the stamp away to someone who wants the stamp more than the cash.”
If This Happens To You, Don’t Panic
The stock market is meant to ebb and flow; that friction makes the economy go ’round, so if you see your stocks dropping, keep perspective and don’t rush to yank out your investment, unless there are other serious red flags.
“It can often be alarming when you pull up your account balance just to find that your hard-earned money that you invested in a particular stock has decreased in value,” said Jake Falcon, CRPC, CEO at Falcon Wealth Advisors. “It’s important to not panic when you see this. We recommend you take a step back and put things in perspective.”
Revisit Your Financial Goals
If your stock drops, take time to take inventory and assess your goals.
“Market fluctuations are a natural part of investing, but significant drops can serve as a wake-up call to reassess your strategy,” said Emmy Sakulrompochai, head of investment advisory product at Arta Finance. “This is the time to ask yourself whether you are comfortable with the volatility of investing in the stock market. If you find yourself overly stressed about market dips, your portfolio might be more aggressive than you’re truly comfortable with. Adjusting your investments to better match your risk tolerance can provide a peace of mind. If your portfolio is too aggressive for you, you may want to diversify into other asset classes that are more stable such as bonds. Furthermore, your investment strategy should be tailored to your personal financial goals, whether it’s saving for retirement, buying a home or funding education.”
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This article originally appeared on GOBankingRates.com: When Stock Prices Drop, Where Does Your Money Go?
