Where does the wealth go when asset prices go down?

It vanishes into nothingness.

“Fugayzi, fugazi. It's a whazy. It's a woozie. It's fairy dust. It doesn't exist. It's never landed. It is no matter. It's not on the elemental chart.” — Mark Hanna

I’ve been writing a lot about the crashes in the stock and crypto markets. Sometimes I say stuff like “Over $2 TRILLION of notional value has now been wiped out compared to the peak in late 2021.” And some people have been asking me: Where did all that wealth go?

The short answer is: It didn’t “go” anywhere. It vanished. It stopped existing. That’s not a natural or intuitive idea — how can wealth just disappear? — so this post is an explainer of how that works. And as we’ll see, this has implications for policy, for how we think about inequality, and for how we plan our own financial futures.

Wealth isn’t like water

A natural — but wrong — way to think about wealth is like a liquid, getting poured from one container into another.

This is not how wealth works.

But this isn’t how wealth works. It’s not conserved, like energy or momentum. It’s not even usually conserved, like mass. It can be created and destroyed, and in fact it is created and destroyed in pretty large amounts every day.

Now when I say “wealth gets created and destroyed”, I don’t just mean that the economy grows, or houses get destroyed by fires, or new companies start up, or old companies go bankrupt. Yes, all those things do create or destroy wealth. But I’m talking about something else here. Financial wealth gets created and destroyed not just because the real economy changes, but because the amount we pay for financial assets changes.

Ultimately, wealth isn’t a physical property of the Universe itself. It’s just how much humans value stuff like stocks, crypto, bonds, houses, or gold.

Mark-to-market accounting: How market prices determine wealth

To understand how wealth works, we first need to understand what “mark-to-market accounting” means.

Mark-to-market accounting means that ALL shares or units of an asset are valued at the market price. The market price is the price of the shares that get TRADED.

Suppose there are 1 million total shares of stock in Noahcorp, but that only 1000 shares of Noahcorp get traded on any particular day. And most Noahcorp shares just sit in people’s accounts and never even get traded at all. Now suppose that the 1000 shares that DO get traded go for $300 a share. Mark-to-market accounting means that we value all 1 million Noahcorp shares at $300 a share, including all the ones that never get traded. So the total value of all 1 million shares of Noahcorp — which is called Noahcorp’s “market capitalization” or “market cap” — is $300 million.

Now suppose that tomorrow, those 1000 Noahcorp shares get traded for only $200 a share. The mark-to-market value of the traded shares and the non-traded shares alike goes down to $200 a share. So Noahcorp’s market cap goes down to $200 million.

Noahcorp’s market cap is wealth. So when Noahcorp’s market cap goes down, where did the wealth go? It vanished. It ceased to exist. There aren’t more dollars out there. The number of Noahcorp shares is the same. The only thing that changed is that now people decided to buy and sell Noahcorp shares at a lower price. So mark-to-market accounting says Noahcorp is worth less than before. There is simply less wealth in the world.

But don’t people “pull money out” of a stock and put it somewhere else?

“But Noah,” you may ask, “when the price of the Noahcorp shares fell from $300 to $200, doesn’t that mean that people pulled their money out of Noahcorp and put it somewhere else?”

First of all, the answer to that question is “No.” It doesn’t mean that. You can personally pull your money out of a stock and put it into another stock, sure. But the market as a whole doesn’t work like that, because when you pull your money out of a stock, someone else puts exactly the same amount of money into that stock.

Here’s how that works. Suppose I sell you a share at $300 today and tomorrow you sell it back to me for $200. All that happens is that $100 of cash went from your account to my account over the course of those two days (Thanks!). The value of Noahcorp has gone down but there’s no more cash in our combined accounts than there was two days ago. No money has been “put in” or “pulled out”, but the amount of wealth in the world has changed.

But the even deeper answer is that this doesn’t even matter, because most shares don’t even get traded. Remember, in this example, only 1000 shares out of a total of 1 million get bought and sold every day. When the price of the 1000 traded shares drops from $300 to $200, the other 999,000 shares go down in value even though they don’t change hands.

The drop in the value of those other 999,000 non-traded shares happens not because they’re traded, but because we infer their price from the price of the few shares that do get traded. The “tail” of the traded shares wags the “dog” of the non-traded shares.

Liquidity: When mark-to-market accounting doesn’t work

So, it’s worth mentioning that not all assets can be valued using mark-to-market accounting. Some assets are illiquid — they almost never get traded. For these assets, we have to determine their value some other way.

The best example is your house. Every share of Noahcorp is identical, but every house is different, so the sale price of other houses doesn’t automatically tell you how much your own house is worth. And your own house almost never gets sold. Your own house is very “illiquid”.

So how does the value of your house get determined? By appraisal. An appraiser comes by and says how much they think your house would sell for if you did sell it.

For houses this is really the best we can do. For some assets, there’s an argument over whether or not to use mark-to-market accounting or some form of appraisal. For example, in the financial crisis of 2008, some banks tried to argue that because their financial assets (CDOs and the like) were highly illiquid, that they shouldn’t be forced to use mark-to-market accounting to value them. If they were forced to use mark-to-market accounting, they argued, there would be a fire sale and the price would be unrealistically low, making banks look less solvent than they were. (This debate was resolved when the Fed came in and bought all the illiquid assets from the banks, and ended up making a profit.)

So is wealth just fake?

The quote and the picture at the beginning of this post come from the movie The Wolf of Wall Street. In that scene, stockbroker Mark Hanna (played by Matthew McConaughey) explains to rookie Jordan Belfort (Leo DiCaprio) that stock prices aren’t real, and that only cash is real. Reading me talk about how the price of 1000 traded shares of a company can determine the price of the other 999,000 untraded shares, maybe you’re starting to wonder if Hanna is right, and the numbers we use for wealth are simply fake.

Well, in fact, it is a little bit fake. Not entirely, but a little bit. The reason is something called price impact.

To go back our previous example, imagine if one guy (let’s call him “Noah”) owned 999,000 of the shares of Noahcorp. The price of Noahcorp shares — and therefore, the value of Noah’s wealth — would be determined by the remaining 1000 of the shares that did get traded. So if the price is $300 per share, then Noah’s wealth is $299,700,000.

But now imagine that Noah tried to sell all his shares of Noahcorp at once. The price would probably go way down. This is because in real life, asset prices aren’t determined only by fundamental value (Noahcorp’s earnings and cash flows and such), but by supply and demand. When Noah dumps his stock onto the market, it increases supply by 1000x. That’s probably going to tank the price.

So Noah won’t get $300 a share. As he keeps selling more and more shares, the price will go lower and lower. By the time he sells all his shares, he’ll have much less than $299,700,000 in cash. In a sense, that means that some of his $299,700,000 in wealth was always somewhat “fake”. There was simply no way for him to get that much in cash, because of price impact.

In fact, there can be other reasons for price impact besides just increased supply. If Elon Musk decided tomorrow to dump all his Tesla shares, people might conclude that there was something deeply wrong with Tesla, and the price would go down.

Price impact can affect the value of whole asset classes, not just individual stocks. For example, our best estimates suggest that crypto ownership is extremely concentrated. That means that if the “whales” who own most of the Bitcoin and Ether all tried to cash out, the amount of cash they got would be significantly lower than their wealth today would indicate. This isn’t just true of the whales, either; if crypto owners as a whole tried to dump their crypto, there would be massive price impact, because the people who don’t currently own crypto would have to buy it all, and they will probably value it a lot lower than the people who currently own crypto.

So does this mean that “true” wealth inequality — that is, inequality of potential purchasing power — is less than the headline numbers suggest? Well, yes, a bit less.

“But Noah,” you may ask, “if price impact means the wealth numbers are somewhat fake, then why don’t we calculate wealth as the amount of cash you COULD get out if you DID sell?”

Well, the answer is: Because we can’t. We just don’t know. The only way to find out price impact is to actually sell. So we can’t really calculate how much cash people could get from selling all their stock or all their Bitcoin, because we don’t actually have any way of knowing how much it is in advance.

So what’s the upshot here?

So why does any of this matter? Well, first of all, don’t assume that the price of some asset class going down means that money is “flowing” somewhere else in the economy. That just isn’t how it works.

And sometimes people will assure you that drops in asset markets don’t mean anything because no actual wealth was destroyed. But paper wealth is as “real” as wealth gets, and people whose assets get marked down may cut back on spending, which affects the real economy.

Second, take wealth numbers with a grain of salt. Yes, the rich people are all actually rich, but the net worth numbers you read in the Forbes 400 or on Wikipedia are more like indicators than exact measures of how much stuff someone could buy.

Third, in my opinion this should make people reconsider their support for taxing unrealized capital gains. There are some good arguments in favor of this approach, but at the end of the day, A) price impact, and B) the fact that asset values fluctuate based on the price of just a few traded shares mean that some portion of the gains you’ll be taxing will just be “fugazi”. (Allowing tax-loss carry-forwards alleviates some of this issue, but not all of it, since not every gain is preceded by a loss.)

Anyway, I hope this explainer was helpful (and to the people who already knew all this stuff, at least not boring). Pretty basic stuff, but fun and important to know!

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