Tuesday, December 02, 2008

Fictional stock market wealth - An Explanation on How Wealth is Created and Destroyed...

Explained: Fictional stock market wealth

For example, let`s say five people each own one share of a company that has only five shares. Let`s say each share is worth $10. How much money is there total? Well, it`s five times 10, so that makes $50.
Now, let`s say that one of these five people decides to sell his share to his friend, but he`s convinced his friend to buy it for $20 (a profit of $10 to the seller). He sells one share to his friend for $20. What`s the share price now, for the whole company? The share price is $20 because the share price is based on the last sold price. Now there are five people and each of them has one share that`s worth $20. Suddenly, there`s $100 total instead of $50 total. All five people think they`ve just doubled their money!

That`s what happens in the stock market. See, all five people think they`re getting rich. But what really happened is that one idiot bought the stock at double the price. There was no new customer, no new business revenue and no new profit. There was just one guy who overpaid for the stock. That`s how fictional wealth is created in stock market exchanges. It`s just an illusion. Where did this extra $50 come from? It came out of nowhere. It`s just numbers on paper.

The reverse also happens. Let`s say there are five people who now own stocks that they think are worth $20, because that`s what one person paid. Then, one person decides to sell the stock but can only sell it for $10. Suddenly, the stock price for the entire company drops to $10. Now these five people who thought they had $20 each just lost $10. They lost half their equity in the company. Now they only have $10 each, and the total worth is now $50. Where did the other $50 go? Well, it didn`t go anywhere because it didn`t exist. It was just on paper. This is what happened during the dot-com boom, except that larger sums of money were involved.

What does all this have to do with home loans? Banks loan money to people based on their individual assets, and those assets include fictional wealth that only exists as numbers on paper (or bytes in a computer database, actually). And these numbers can be easily distorted by irrational buyers who overpay. As a result, many banks are making home loans using little more than thin air as the assets backing the loans.

This is how a real estate bubble happens at the same time as a stock market bubble. This is San Francisco in 1999. This is Silicon Valley in 2000. It`s exactly what happened. At that time, I was warning about the looming stock market crash, and it was poorly received. A few people listened and they sold their stocks and were safe, but most people didn`t. They said, "You`re crazy. This thing is going up forever. We are all rich. We are all rich!"

But I knew better. When you sell a share and you have cash in your hand, then you can count it as money. Until then, it`s just whatever somebody else paid for it. My point in explaining all of this is that I`ve told this same story to financial advisors. They would look at me and say, "What? I don`t get that. What do you mean? What do you mean that money is created out of thin air?" They don`t get it. When the dot-com crash happened, billions of dollars were lost overnight through that exact same method I just described. Billions of dollars did not fly away. Those dollars did not get transferred into some rich person`s pocket, which is what most people believe. They think rich people ran away with the money. That`s incorrect. The money never existed in the first place. The money disappeared overnight because suddenly the stock price was dropping rapidly.

Eh, undersood?

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