Paper Wealth

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May 28, 2011 by huionn

My friend sent me a link of an article which foresees US property market crash –

It has a section about paper wealth which is very insightful.

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.

Learn more:

In the example, $10 can create/destroy paper wealth of $50 in value.

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