This morning I received an email from FirstLadyMaven with a link to an article on Freakonomics. I was initially drawn in by the intriguing title, but later found myself disagreeing with the author’s connection between socks and stocks. Here is a excerpt from the article (Click on the link above to read entire article):
“Stocks, like money itself, have an explicit value and an implicit value. Back in the day, when currencies like shells and salt fell out of fashion, it was their implicit value that plummeted; their usefulness didn’t change. Similarly, in a market panic, a stock’s value may simply vanish — like your socks in the dryer. (Keep this in mind when the stock market starts to rise, for that value too is as implicit as a barn full of salt.)”
As I understand it, the author is saying that when stocks lose value, the money disappears like socks do in a dryer. While this is a comical answer, I feel it is an easy way out of the question, “Where did the value go?” Or better yet, “How did I lose my money?”
A common question I am asked by relatives and friends is, “Why is the value of my 401K or IRA so much lower then it was a couple years ago?” The answer: Supply and Demand. I know that may sound harsh and impersonal, but its the unadulterated truth. Let me give you an example.
You open a retail store in the spring of 2009 in Chicago, IL. You want to sell name brand t-shirts in your store. You buy 50 t-shirts from a wholesaler for $5 a shirt (So that is $250 inventory cost). The suggested retail price for the t-shirts is $50. These are some really sweet t-shirts. So you do the math, and you are looking to make $2,500 if you sell all 50 t-shirts at $50 each (Update: that’s potentially $2,250 in profit). As spring and summer pass by you only sold 1 t-shirt, and that was to your best friend at cost. So you haven’t made any profit yet. Now the fall season is setting in and its getting colder. So you decide to have a 50% off sell to hopefully sell the other 49 t-shirts. But, by Christmas you still have only sold half of your inventory, and worse still the t-shirts are no longer in style. So you are forced to sell the t-shirts at half the price you paid at $2.50 just to recoup your initial cost.
In the example above you see there were many contributing factors to supply and demand, such as the season change and change in clothing trends. These factors caused the price of the t-shirt to drop dramatically. The suggested retail price is never realized until a t-shirt is actually sold at $50. This same correlation happens with your 401K or IRA as well! The price you pay for a stock is your initial cost. Your expectation of the price of the stock to go higher in the future is like the suggested retail price. When you saw your 401k go up over the past several years, what you saw was the suggested retail price go up. You hope and expect the stock to sell at the higher price to make a profit, and you hope it does not sell at a lower price than what YOU paid for it. Stocks follow trends, and have different behavioral patterns during different seasons. If you have to sell at a lower price, the money did not “vanish,” it was willfully given up when you bought the stock from the seller.
Remember money never vanishes, it’s just in someone else’s pocket!