When Stock Prices Drop, Where Is the Money?

Have you ever wondered what happened to your socks when you put them in the dryer and never saw them again? It's an unexplained mystery that may never be solved.

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 on to find out what happens to it.

Disappearing Money

Before we get to how money disappears, it is important to understand that regardless of whether the market is rising (a bull market) or falling (a bear market), supply and demand drive the price of stocks. And it's the fluctuations in stock prices (and the points at which you buy and sell shares) that determine 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. You may believe that that money goes 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 do so, the stock price 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 may think that you saved $5, but you didn't actually earn a $5 profit. However, if the stock then rises from $10 back to $15, you will have a $5 (unrealized) gain.

The same is true if you're holding stock and its 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. That's because their entry point is the lower price and they must wait for the stock to rise above that level before making an unrealized (or realized) profit.

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 will decline. This is called short-selling.

If the stock price falls, the short seller profits by buying the stock at the lower price and closing out the trade. The net difference between the sale and buy prices is settled with the broker.

Although short-sellers profit from a declining price, they're not taking money from you in particular when you lose on a stock sale. Rather, they're conducting independent transactions and have just as much of a chance to lose or be wrong on their trade as investors who are long (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, due to the decrease in demand for the stock, or, more specifically, the decrease in enough investors' favorable perceptions of it to move the price down by selling.

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 in value because their asset is now worth less than its original price. Again, no one else necessarily receives the money; it simply vanishes due to investors' perceptions.

Explicit Value

Now that we've covered the above 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 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.

Without explicit value, the implicit value of the company would not exist. Investors' interpretation of the financial health and performance of a company is based on its explicit value. Explicit value is the force behind the stock's implicit value.

Disappearing Trick Revealed

Let's say Cisco Systems Inc. (CSCO) had 5.81 billion shares outstanding. This means that if the value of the shares dropped by $1, the loss would be equivalent to more than $5.81 billion in (implicit) value.

Because Cisco has many billions of dollars in concrete assets and makes profits, 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.

The Explicit Drives the Implicit

So faith and expectations can translate into cold hard cash, but only because of something very real driving perception. That's the capacity of a company to create something useful and needed by people and businesses.

The better a company is at creating something for which there's demand, the higher the company's earnings will be, and the more faith investors will have in the company.

The Bottom Line

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, investors participating in a bull market can make money.

Of course, the exact opposite can happen in a bear market. In other words, the stock market can be seen as a huge vehicle for wealth creation and destruction.

No one really knows why socks that go into the dryer never come out, but the next time that you're wondering where that stock price came from or went to, at least you can chalk it up to investor perception.