Housing market crashes and fictional stock wealth

This is pretty fascinating… Written from an American perspective but the economic points he makes are universal, and I’m sure it could happen here: Warning signs of the housing bubble crash (part two). From “yay, we’re going to make loads of money” to “oh no, the bank is repossessing the house and we’ll still owe them a fortune” in six easy pieces.

My favourite part is the explanation of how fictional wealth is created on the stock market:

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.

This explanation is slightly incorrect in the details. After one of the five shareholders sells his share to someone else, there are only four shareholders remaining, not five, but the explanation still talks in terms of fives. But you can see why, and the underlying principles are unaffected by this inaccuracy and more clearly illustrated for it, I’d say.

Now, for literally years I’ve been reading about people having, and losing, “fortunes on paper” without really understanding what it actually meant or how it could happen. “Why did all these people lose their money?”, I wondered. “Why couldn’t they sell their stock when it was up?” Well, now I understand: some did get out, but once the market started correcting, that immediately stopped happening for everyone.

How to prevent this? Seems to my untrained brain that the critical part is the statement in boldface: the share price for everyone is defined by the last sale price. There’s got to be a better way to do this? Surely you could base it on some sort of aggregated calculation over some subset of all sales. Presumably mean sale price over all sales would be too crude – you’d want recent sales to count more than older ones. Or would what I’m suggesting just slow the problem down, but not eliminate it? I Am Not An Economist, as you may have guessed. :-) Anyway, good stuff.

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.

2 Responses to “Housing market crashes and fictional stock wealth”

  1. January 10th, 2006 | 5:08 pm

    After one of the five shareholders sells his share to someone else, there are still five shareholders – the original five, micus the seller, plus the new buyer.

    Am I missing something obvious here?

  2. January 10th, 2006 | 10:52 pm

    You’re absolutely right. I had foolishly misread “his friend” as “his fellow shareholder”, probably through overparellising the story with a familiar situation close to home.

    Thanks for the correction, Simon.