Imaginary Wealth

The current fall in the stock markets has wiped out about Rs. 39 lakh crores (0.8 trillion US Dollars at current exchange rates) in market capitalisation off the National Stocks Exchange since the begining of the year. This is equivalent to the GDP of India for 2007-08. The entire output of the country has been wiped out in 10 months in the stock markets!!

If you include the fall in value of other assets like commodities, real estate, etc, the total wealth destruction could go well beyond Rs. 100 lakh crores. So many people have lost so much wealth. So many investors have had massive wealth destruction.

Or have they?

Have investors really lost wealth? I would tend to think no.

Consider the following example. Lets assume that there are 4 investors A, B, C, D, each with 500 shares of stock XYZ. The current market price of stock XYZ is Rs 100 per share. So the value of each investor's holding is Rs 50000. Collectively they own Rs 200000 worth of share XYZ.

Along comes investor E and buys just 1 share of stock XYZ from investor D at Rs 110 per share. He pays D Rs.110 and gets one share in return. This price now becomes the market price for everyone. At Rs. 110 per share, the value of the shares held by investors A, B and C becomes Rs. 55000 each. The value of shares of investor D becomes Rs, 54890 (499*110) plus he has Rs 110 as cash received from the sale of 1 share of XYZ. The sum total of the wealth held by all investors now becomes 220110 (Rs 55000 each for A, B, C, D and Rs 110 as value of share held by investor E). The total wealth went up without any productive activity.

Now for some reason, E sells off the one share he had purchased from D to another investor F at Rs 90. He accepts a loss of Rs 20 (110-90), but the new price of Rs 90 becomes the market price now. Everyone who owns any share of XYZ now has to value his shares at this price. The value of shares held by investors A, B, C now becomes Rs 45000 (500*90) each. Investor D has a worth of Rs.45020 (499*90+110). Investor E has a net worth of Rs -20 as he lost Rs 20 and investor F has a share worth Rs. 90. The total value across all investors is now 180090 (45000*3+45020-20+90)

All investors, put together, have lost Rs. 40020 (220110-180090)! Just one share sold by E to F caused wealth destruction by Rs. 40020! Does it seem right? How is it possible that such an insignificant action can result in loss of wealth by such a significant amount (20% of the initial sum of Rs 200000 together)? And where has the money gone? Surely, if someone lost, someone else would have gained that amount, right? This money has to go somewhere, right?

Wrong! The wealth has simply vanished. It has disappeared into thin air! How is that possible? How can something vanish suddenly?...unless it never existed in the first place!

Precisely! There was never any wealth to begin with (or at least not as much as dictated by prices). It was all 'maya'. Just as wealth went up when prices went up, wealth went down when prices went down. All imaginary, all an illusion.

Asset prices rise even if just one buyer and one seller agree on that price. This impacts all those who hold the asset even as they do nothing to influence this price. Conversely, just one buyer and one seller who agree on a lower price of an asset are enough to get down the wealth of all others who hold that asset. We see this all the time in the markets. When markets have gap-up or gap-down openings, it is usually only one buyer and one seller who make the market.

The wealth that an investor holds lies merely in the mind of that investor and in the minds of those who agree with him. When the point of agreement changes, so does the value of the holdings in the assets. Wealth instantaneously turns into thin air. Looking at it in another way, in reality, the investor never has any wealth. All his wealth is merely illusionary, based on what others thought the wealth to be. And when others think what your wealth is, it can disappear in the blink of an eye.

So in the current meltdown, Mukesh Ambani did not lose 40 billion Dollars. He never had that to lose. K.P.Singh (DLF promoter) did not lose 85% of his wealth. He never had that to lose.

Consumerism is good. But comsuming using wealth that never exists is potentially dangerous. As people in the USA have discovered. Rising home prices gave an illusion of wealth increase. People capitalised on this 'wealth' by borrowing money from banks against this 'increase in wealth'. Banks also lent out on such illusion. Now the magic trick is over and everyone has begun to realise that all that wealth against which consumers borrowed and banks lent, actually never existed except in their minds. The ill effects are there for all to see.

Wealth is not the value of the assets we hold. Indeed, wealth is something that we value in our life and not the money in our bank account or the value of our homes and stocks. Wealth is created by productive activity and its voluntary exchange for something else, and not by a series of passing the assets' parcel at higher and higher prices. When a car manufacturer processes raw materials, manufactures a car and sells it to a consumer, wealth is created for the car manufacturer (and not to the owner of the car). When a plumber fixes a leak on our request, he creates wealth for himself. When the government taxes us to pay its unproductive employees who do nothing, wealth is destroyed.

Here's to more productive activity! Here's to more wealth for everyone!