Saturday, January 10, 2009

Where Did the 2008 Investment Losses Go?

It's been estimated that the investment losses from 2008 are between $6 to $8 trillion. As a result, many people feel poorer. So, where did the money go? According to Trillions Disappear in Stock Market, but Where Did Money Go? at reports the money never really existed, except in the minds of owners, and therefore, didn't really disappear. The high values were simply "readjusted," once the true value was known. In other words, until the money is in one's hand, the money doesn't exist.

Here's an example I once heard that illustrates the point:

Investor A owns a can of sardines, which he purchased for $1. Investor B would like to buy it but doesn't have money. Instead B offers A a note (a pledge to repay money) of $10, which A accepts. So A now has a note worth $10 and B has a can of sardines with a value of $10.

However, A later decides he wants the sardines back. Since he doesn't have any cash, he offers B a $50 note for the sardines, which B accepts. Now A has a can of sardines with a value of $50, and B has a note worth $50. This process continues until one has a can of sardines worth $100,000 and the other has a note with a value of $100,000. In the end, A and B can both claim to have $100,000 in investments, in the form of a can of sardines and a note.

However, since no cash transaction has been made, the values are inflated and exist only as estimate. In reality, the can of sardines would could only sell for about $1 in cash and the note has very little value since neither A or B have the money to repay the note. Once the market "realizes" this fact, the value of the can sardines and the note will fall back to $1, which is what someone with cash would pay. The other $99,999 never really existed since no cash was transferred.

Lesson learned: Market values can quickly disappear, cash in hand does not (at least not for now).

For more on Reflections and Musings, check back every Saturday for a new segment.

This is not financial advice. Please consult a professional advisor.

Copyright © 2009 Achievement Catalyst, LLC


Anonymous said...

I love your example. So simple, yet so effective.

VC said...

Good post, it's a good example of how the market always corrects itself.