07 January 2009

Someone Must have my Money

Over the last few months, I've seen a number of people on the internet saying something like 'Where has all my money gone? Someone must be benefitting from it.'

I'm going to go where angels fear to tread and try to explain why no-one has 'stolen' your money and why 'you never had it in the first place'.

This post is not going to use financial jargon and won't satisfy the financial version of the question 'How many angels can dance on the head of a pin'? I want to try to communicate in simple terms why no one has stolen money from your investments. And I'm going to stick with explaining stocks and shares (equities) because that's my area of knowledge. I'll leave someone else to to explain 'fixed income and bond pricing for beginners'

First A Really Simple Explanation

You know the chap who insists that his house is worth £125,000 and that he's not going to accept a penny less? When the house across the street that is exactly the same as his house (but in better decorative order) gets sold for £100,000 this chap still insists that
his house is worth £125,000.

Silly man, we say. A house is only worth what someone is prepared to pay for it. It's not worth £125,000 just because you say it is.

Well, exactly the same principle applies to stocks and shares. They are worth what people are prepared to pay for them. And just like people are willing to pay less for a house in a housing slump, so too are people willing to pay less for stocks and shares in a recession.

A Bit More Complicated Explanation

Suppose I start a business manufacturing widgets. I invest £1000 to build a factory and to buy all the raw materials I need to manufacture widgets. Some people might say that my business is now worth £1000, because I can sell my factory and raw materials for £1000. Some people might say that my business is now worth £900 because my used kit won't command full price on the second-hand market.

Now suppose I have a reputation for being the very best widget maker in the world and I've just left United World Conglomerates to go out on my own as a specialised widget maker. My mythical economy is growing at 4% and the widget market is growing at 8%. But people think that because of my know-how and reputation, I can grow PamBG's Widgets at a rate of 20% per year and they think that I can do this easily for the next 5 years (I'm going to grab a lot of customers away from UWC.) They might then decide that my business is now worth £2239.49 (£900 compounded by a simple 20% for 5 years).

'Wow!' I say. 'I thought my business was only worth £900 but it seems that everyone out there thinks that it's actually worth more than twice that amount! They think it's worth £2239.49! Fantastic!'

You can see where I'm going, I think. Suppose the economy suddenly slows from a 4% growth rate to a 1% growth rate. But people only want to buy widgets when the economy looks good. Suddenly, instead of the demand for widgets growing at 8%, it's now growing at 1% - same as the economy.

'Woah! Hold on!' People say. 'PamBG's Widgets is the best around but when we thought her business was going to grow at 20% a year, we thought the widget market was growing at 8% a year! Now we think PamBG's Widgets is only going to grow at 2.5% per year, so actually we now think the business is really worth £1018.27 (£900 compounded by a simple 2.5% for 5 years) and that's all we're prepared to pay for it.'

So, did I lose over £1000? No, I never had it in the first place. No one has 'taken' that money from me and no one has 'stolen' it from me. No one now has £1000 in cash to go out and spend that I used to have. That money never existed.  In the same way that the chap who thought his house was worth an 'extra' £25,000 never had that money in his hand to spend.

5 comments:

Will said...

Have some people actually been saying that someone has 'stolen' their money?

PamBG said...

Yeah. 'Where did it go and who is benefitting from it?'

Judy said...

Yes, but......
What if I invested $1000 cash in a mutual fund and they invested in a stock, and so forth, such that now my original $1000 is $800? That is the risk, my risk, but it is my money that is gone. Sure, my house and my widgets are only worth what you will pay for them. But if I paid $10000 (where do I find this mythical house for $10000) and you only pay me $8000, then I lost $2000 cash. So, who has my money?

PamBG said...

Judy, absolutely your money is gone.

I'm hearing people saying something akin to the idea that the stock-market crash was arranged by financial insiders in order to take people's money away from them. I'm saying that markets don't work that way.

I do have a lot of issues about what's been happening with credit. And, funnily enough, that was my second post back when I started this blog: Debt, debt and more debt That was back in the days when 'Everything was fine'.

And I think that what has happened with consumer credit is analogous with credit card lending, mortgage lending and the banking crisis.

Sally said...

very good Pam, thank you