Where does money go when markets crash?
“Brexit crash wiped out a record $3 trillion,” the headlines screamed after the UK voted to leave the EU. It is not uncommon to read such headlines in the financial media which usually comes following a stock market crash. But what exactly does it mean? Where was the $3 trillion to begin with and how can money just disappear into thin air? In a stock market collapse do people really lose their pension and invested money? Who gets the lost money? Certainly the lost money can’t just vaporize can it?
A quick answer to the above question is “There was no $3 trillion to begin with.”
Read on below to get a more clear understanding of how money works in the stock market and more importantly how money is said to disappear during a stock market crash of a financial market collapse.
In the financial markets, more specifically the equity or stock markets, stocks represent a share of ownership in the company. The price of the stock is what investors believe it is worth. In this context, if the stocks were valued at $10 trillion yesterday and today the stocks were valued at $7 trillion, then if you hear someone say “$3 trillion wiped out of the markets“, it simply means that the stocks are now valued $3 trillion lesser. It is valuation that has come down, not actual money.
Bear in mind that it was the valuation and there was no $10 trillion sitting in a vault or at the stock exchange. It is merely perception and not anything else. Although one could be forgiven for thinking that the money mentioned in real money and not valuation, which is what the media refers to.
What is market valuation?
Market valuation is the price at which an asset is said to trade in a competitive auction. Market valuation is different from market price, which is the price at which one can transact. Market value and market price are same or equal only under an efficient market also known as equilibrium. It is for this reason there is a large group of stock investors who call themselves, value investors. The biggest name under value investors is Benjamin Graham who is considered the father of value investing and his protégé, Warren Buffet. In this form of analysis, value investors look for the true value or intrinsic value of a stock, then determine if the market price or stock price is trading at a premium (above its market value) or a discount (below its market value) and thus pick stocks.
Robert Shiller, an economist and a Nobel Laureate puts it succinctly, calling it a fallacy. “The price of a stock has never been the same thing as money — it’s simply the “best guess” of what the stock is worth. We’re just recording a measure of what people think the stock market is worth. What the people who are willing to trade today — who are very, very few people — are actually trading at. So we’re just extrapolating that and thinking, well, maybe that’s what everyone thinks it’s worth”
When do you really lose money when a stock market crashes?
Investors can really lose money if they sold their shares at a lower value than what they bought. For example, here is a chart of the Royal Bank of Scotland Group PLC. Assume that you bought one share at 207.20 on 7th April 2016. After the Brexit fall out when the stock tanked, RBS is now valued at 170.30. So if you decided to sell your one share of RBS at 170.30, you have lost £36.90. Now if you had purchased 5000 shares of RBC at 202.20 and sold at 170.30 after the markets crashed, you would have made a loss of £184,500.
Can you make money despite a stock market crash?
You can, as long as you have the gut to hold on while the stock price is still slipping. A better way to illustrate this is to look back at the 2008 global financial crisis, which was another major global event that wrecked havoc in the financial markets. Let’s take a look at General Electric (NYSE: GE). Assume you bought 1 share at 29.95 on 5th of May 2004. The stock price fell following the 2008 crisis and hit a low of 8.00. If you had held on to that investment, then by 1st of December 2015, you would have sold your stock at $30.70, and made a profit of $0.75.
So remember, the next time there is a market crash and you hear that billions or trillions are wiped out, it is merely the market value and not real money.