Understanding The Stock Market

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

When a stock market price for a company suddenly takes a nosedive, a stakeholder may wonder where the money they invested went. Well, the answer's not so simple as "someone pocketed it."

Money that enters the stock market through investment in a company's shares stays in the stock market, though that share's value does fluctuate based on a number of factors. The money invested initially in a share combined with the current market value of that share determine the net worth of shareholders and the company itself.

It may be easier to understand this given a specific example such as three investors — Becky, Rachel, and Martin — entering the market to buy a share of Company X, wherein Company X is willing to sell one share of their company in order to increase capital and their net worth through investors.

An Example Exchange in the Market

In this scenario, Company X has no money but owns one share that it would like to sell the open exchange market while Becky has $1,000, Rachel has $500, and Martin has $200 to invest. If Company X has an Initial Public Offering (IPO) of $30 on the share and Martin buys it, Martin would then have $170 and one share while Company X has $30 and one less share.

If the market booms and Company X's stock price goes up to $80 per share, then Martin decides to sell his stake in the company to Rachel, Martin would then exit the market with no shares but up $50 from his original net worth to now total $250.

At this point, Rachel has $420 left but also acquires that share of Company X, which remains unaffected by the exchange.

Suddenly, the market crashed and Company X stock prices plummet to $15 a share. Rachel decides to opt out of the market before it goes any further down and sells her share to Becky; this places Rachel with no shares at $435, which is down $65 from her initial net worth, and Beck at $985 with Rachel's stake in the company as part of her net worth, totaling $1,000.

Where The Money Goes

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. Martin, who gained $50, and Company X, who gained $30, have collectively gained $80, while Rachel, who lost $65, and Becky, who is sitting on a $15 investment, collectively lost $80, so no money has entered or left the system. Similarly, AOL’s one stock loss is equal to Becky’s one stock gained.

To calculate the net value of these individuals, at this point, one would have to assume the current stock exchange rate for the stake, then add that to their capital in the bank if the individual owns stock while subtracting the rate from those who are down a share. Company X would, therefore, have a net value of $15, Marvin $250, Rachel $435, and Beck $1000.

In this scenario, Rachel's lost $65 has gone to Marvin, who gained $50, and to Company X, who has $15 of it. Further, if you change the value of the stock, the total net amount Company X 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 Company X 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. Marvin 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.

Why Does Company X's Value Increase When Stock Prices Fall?

It is true that Company X's net value does go up when the stock price goes down because when the price of the stock plunges, it becomes cheaper for Company X to repurchase the share they sold to Martin initially.

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 Company X does not gain or lose any cash from changes in the share price.

Lastly, consider Rachel's situation. If Becky decides to sell her share to Company X, from Rachel’'s perspective it doesn’t matter what price Becky charges Company X as Rachel will still be down $65 no matter what the price. But unless Company 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.