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A Myth About Wealth Destruction

There is a common myth about wealth destruction that is quite dangerous. The myth is that when certain markets crash or lose a lot of value, the value that was lost was not "destroyed" but has simply gone into another investment or market. One of my recent posts highlights an article from Dylan Grice regarding safe havens that was a decent read, however there was one quote in the article with which I took issue:

"For all the headlines about the billions wiped off stock market values during market routs, that money had to go somewhere. It doesn’t just disappear."

First of all, I deeply respect Dylan Grice and generally find myself agreeing with many of his positions. However, I do disagree with this concept that "money had to go somewhere" and that money does not just "disappear". Simply put, when market valuations plummet, that is exactly what happens, that which was considered "money" disappears and is gone unless and until valuations recover.

Market valuation is based upon the intersection of price for which a seller is willing to sell and a buyer is willing to buy. The entire stock valuation of a company could be based theoretically on the decision of two market participants, a single buyer and a single seller, to exchange stock for a certain valuation. When markets crash, buyers dry up (aka "disappear") until valuations reach a low enough level to attract interest. When panic or economic distress sets in, sellers may be willing to sell at much lower valuations that reflect this lower interest on the part of the buyers. Even if only 5% of the current investors of a particular stock plan to sell at lower valuations, it impacts the price for 100% of the investors. If XYZ company had a total of 100,000 shares valued at $100 a share, XYZ would have a "value" of $10,000,000. Someone who owned 10% of XYZ stock would own stock worth approximately $1,000,000. If the market for XYZ stock crashed and there were only buyers and sellers exchanging XYZ stock at $50 per share, then XYZ would be valued at $5,000,000 and a person owning 10% of XYZ stock would have seen their holdings drop in half even if they did not sell their stock. 

If XYZ stock remained at $50 for an extended period of time, where did that "money" or "value" go? It is lost or destroyed for those investors who sold or who hold the stock of XYZ at lower levels. It is not as if investors exited the stock at the peak, held onto the cash and are simply waiting for a better time or investment to consider redeployment. The majority of individual investors get out of a crashing stock market closer to the bottom and lock in their losses--this is truly wealth destroyed, money that just disappears. Even investors who hold on to stocks are subject to the same wealth destruction if that which they own sustains long-term losses in terms of market valuation. Just because the latter long-term holders have not taken the loss does not make it any less real in terms of current valuation.

Bottom line: market crashes wipe out wealth and that money which is lost is truly destroyed and does not get recycled in other investments.

Written By: Joshua Ungerecht

Dylan Grice, market valuation, Wealth Destruction