When Stock Prices Drop, Where Is the Money?

As stock prices plummet, investors often wonder where their money has gone. In truth, it hasn't vanished—instead, the perceived value of their investment has changed. Stock price shifts are more about changing perceptions of value rather than money physically moving from one place to another.

Say you buy 100 shares of Apple Inc. (AAPL) at $150 each. Later, supply chain issues arise, or a new Apple product underperforms. As a result, investors lose confidence in Apple's future performance, and the stock price drops to $100 per share.

While it might seem like you've "lost" $50 per share, that money didn't go anywhere. The price change simply reflects what investors are now willing to pay for Apple shares. It's like how a new car's value depreciates over time—the actual vehicle hasn't changed, but its market value has.

This "paper loss" only becomes real if you sell your shares at a lower price. Understanding this concept is crucial for navigating the often turbulent waters of the stock market without getting sunk.

Understanding Why Stock Prices Change

Stock prices are fundamentally driven by supply and demand. When demand for a stock is high, meaning more people want to buy than sell it, the price rises as buyers are willing to pay more. But when supply exceeds demand, meaning more people are selling than buying, the stock price tends to fall, as sellers are forced to lower their prices to attract buyers.

This constant interaction between supply (the willingness to sell) and demand (the willingness to buy) drives prices and market trends.

When Demand in a Stock Increases

Let's look at what happens when prices for a stock are going up, using one of the most notable stock rises in recent memory. From 2020 to 2021, the stock price of Tesla (TSLA) surged over 700% despite the pandemic. Investors were bullish on Tesla's potential to dominate the electric vehicle market, its production expansion plans, and CEO Elon Musk's ambitious targets.

By January 2021, Tesla's market capitalization was over $800 billion, making it one of the world's most valuable automakers. This occurred even though Tesla produced only about 500,000 vehicles in 2020, far fewer than traditional automakers like Toyota and Volkswagen.

When Demand in a Stock Drops

Let's now review an example of a stock falling in price. In January 2022, Netflix (NFLX) reported disappointing subscriber growth for the fourth quarter of 2021, adding only 8.3 million new subscribers versus the expected 8.5 million. This might not seem like an astounding shortfall, but the news, coupled with concerns about rising competition, caused Netflix's stock to plummet 21% in a single day.

Investors were worried about slowing growth and potential market share loss to competitors like Disney+, Hulu, and HBO Max. Over the following months, Netflix's stock continued to fall as the company reported subscriber losses in the first half of 2022. By July 2022, Netflix's stock had dropped almost 70% from its all-time high.

Why Do Stock Prices Fall?

More needs to be said, though, about why prices fall, not just that they go down. Stock prices are influenced not just by a company's actual performance, which is part of its fundamentals, but by how investors perceive its prospects. Positive news, such as strong earnings reports or industry advances, can increase demand and higher prices. Negative news, like missed earnings targets or economic downturns, creates fear or uncertainty about stocks, leading to increased selling and lower prices.

Let's go through the major reasons you can see a fall in the price of a stock:

Changes in Investor Sentiment

When a stock's price decreases, it affects investors in several ways. First, a decline in a stock's price directly reduces the market value of their holdings. For instance, if Apple's stock drops from $150 to $140, an investor with 100 shares loses $1,000 in market value.

Price drops also trigger fear and uncertainty among investors, leading to panic selling and creating a feedback loop of further price declines. We saw this in our example above when, in early 2022, Netflix's stock plummeted over 20% in one day after disappointing subscriber growth, prompting many investors to sell.

It's not that the intrinsic value changed immensely in a day, but that negative sentiment fed upon itself. This happens because a falling stock price can negatively influence perceptions of a company's health, leading to a further loss of confidence and stock price declines.

That said, investors react differently to price declines. Some view them as buying opportunities, believing the stock is now undervalued. Others may decide to cut their losses and sell. During the 2022 market correction, for example, some investors saw a drop in the price of Tesla's stock from its 2021 highs as a chance to buy at a discount.

Poor Financial Performance

When a company reports lower-than-expected earnings, profits, or revenue, it signals to investors that the business is underperforming. This very often leads to a sell-off as shareholders lose confidence in the company’s ability to grow, pushing stock prices lower. Missed earnings targets or profit warnings are key triggers for price declines.

Economic Recessions

During periods of economic downturn or recession, consumer spending decreases, and business investments slow down. As companies experience reduced revenues and potential layoffs, their stock values tend to fall. Investors often pull out of equities in favor of safer assets, compounding the decline.

Below is chart showing the S&P 500 performance during recessions (along with major declines that didn't occur during or right before them):

Rising Interest Rates

When central banks raise interest rates, borrowing becomes more expensive for companies and consumers alike. Higher interest rates usually reduce corporate profits and consumer spending, which can drag down stock prices. In addition, rising rates make bonds and other fixed-income investments more attractive, leading investors to shift away from stocks.

Geopolitical Tensions

Geopolitical risks such as wars, trade conflicts, or political instability can create uncertainty in financial markets. Investors often react to these risks by selling stocks, fearing economic disruption or volatility. This uncertainty can lead to widespread market declines, particularly in sectors sensitive to changes in global trade and security.

Major Shareholder Actions

When large institutional investors sell substantial portions of their holdings, it can increase supply in the market, driving down prices. Such moves may be triggered by portfolio rebalancing or reactions to market conditions. These visible transactions can instill fear among smaller investors, leading to further declines.

Sector-Specific Problems

Each industry has specific challenges, such as regulatory changes, supply chain disruptions, or technological obsolescence. For instance, stricter environmental regulations could hurt the energy sector, while rapid technological advances could render products obsolete in industries like telecommunications.

The Effects of Stock Price Declines

When a stock's price falls, the market value of the stock decreases, effectively "erasing" some of the perceived value. This lost value isn't transferred elsewhere; it reflects a shift in what investors believe the stock is worth, driven by changing expectations and sentiment. In short, your loss isn't necessarily someone else's gain.

The lost value in a stock's decline reflects a decrease in the company's market capitalization. When a stock's price drops because of decreased demand and negative investor sentiment, the company's overall market value—calculated as the stock price multiplied by the number of outstanding shares—shrinks.

Here are other effects:

• The stock may be more sensitive to market changes: As stock prices decline, particularly if they fall below certain thresholds (like $5), they become more sensitive to market moves. Often, stocks crossing below the $5 mark have increased volatility and risk.
• Company financing is more difficult: A prolonged decline in stock prices can also affect a company's ability to raise capital. When Ford Motor Company (F) faced declining share prices because of poor sales forecasts in 2020, it struggled to attract investors for new financing rounds. Lower share prices may deter potential investors or lenders, affecting the company's growth prospects and overall financial health.
• Dividends and returns may adjust: A lower stock price might not immediately affect the dividend if the company pays one. However, if the price drop reflects underlying financial trouble within the company, future dividend payments might be reduced or eliminated, affecting income-seeking investors.

Lower stock prices can also affect long-term returns. For long-term investors, a significant drop can take years to recover, potentially delaying or reducing overall investment returns.

How To Prepare for Stock Price Declines

You can take several measures to prepare for potential stock market corrections or for a partial decline in your stock portfolio value:

Buy and Hold

The buy-and-hold strategy involves buying stocks and holding them for the long term, regardless of market fluctuations. Using this approach, investors ride out market volatility. This has often been the right move since, historically, stock prices have trended higher.

Investors should avoid the pitfalls of panic selling during downturns by focusing on long-term growth rather than short-term price movements. This strategy is particularly effective for investors who believe in the fundamental strength of their investments and have a time horizon that allows them to weather market storms.

Diversification

One of the best ways to prepare for a stock market correction or crash is by diversifying your portfolio. Holding a mix of assets—stocks, bonds, real estate, and commodities—helps spread risk. When one asset class declines, others may hold steady or increase in value and this protects your overall portfolio.

Diversification across sectors, geographies, and company sizes further mitigates risk during market downturns.

Keep Cash On Hand

Holding part of your portfolio in cash or cash equivalents gives you a lot of flexibility during market corrections. You can take advantage of lower stock prices by buying quality assets at lower prices.

Cash reserves also act as a safety net, ensuring you don't need to sell other assets at a loss during a downturn. 

You should also have an emergency fund that ensures you have liquid assets available in case of personal financial difficulties or during market crashes when stock values are down. Having three-to-six months’ worth of living expenses set aside in a high-yield savings account allows you to avoid selling investments at a loss in volatile markets.

Manage Your Risks

Implementing risk management techniques, such as setting stop-loss orders or using options strategies, can help protect your investments during market downturns. Stop-loss orders automatically sell stocks when they reach a certain price, limiting potential losses.

Options strategies, such as buying put options, can provide insurance against declines in stock prices. 

Invest in Defensive Stocks

Defensive stocks—such as those in the consumer staples, utilities, and healthcare sectors—tend to perform better during economic downturns and market corrections. These companies provide essential goods and services, making them less vulnerable to shifts in economic conditions. 

Intrinsic vs. Market Value

When evaluating a company's worth, investors consider two main types of value: intrinsic and market.

Intrinsic Value

Otherwise called the fundamental value, intrinsic value is what's taken to be an objective estimate of a stock's actual worth. These are used to assess its value:

• Future cash flows
• Growth rate
• Risks facing the company
• The firm's overall financial health

Here are the essential characteristics of intrinsic value:

• Objectivity: Based on a fundamental analysis of the company
• Calculation: Often uses discounted cash flow and other models
• Stability: Generally more stable than market value
• Purpose: Used to determine if a stock is overvalued or undervalued

Market Value

Market value is the current price at which a stock trades in the market. It represents what investors are willing to pay for the stock at a given time.

Key points about market value:

• Based on supply and demand in the stock market
• Can fluctuate widely
• May not always reflect the company's fundamental value
  
• Studying historical prices and technical indicators help analysts try to predict future market value

Unrealized vs. Realized Losses

Another crucial distinction is between unrealized and realized losses. These concepts have different implications for your portfolio and taxes.

Unrealized or "paper losses," occur when the market value of a stock decreases, but the asset hasn't been sold yet. For example, if you bought 100 shares at $50 each, your total investment is $5,000. If the stock price drops to $30 per share, the market value is $3,000, producing an unrealized loss of $2,000. The loss is called "unrealized" because it exists only on paper; you still hold the shares and could see the stock recover in time.

Unrealized losses don't have immediate tax implications because they aren't recognized until the shares are sold. Many investors hold onto their investments during market downturns, hoping prices will rebound and allow them to make up for their losses. Those who believe a company's fundamentals are stronger than the stock price often do this.

Meanwhile, realized losses occur when an investor sells an asset for less than its purchase price. Going back to the example above, if you sell 100 shares at $30 each, you would receive $3,000. Since you originally invested $5,000, this ends in a realized loss of $2,000. Unlike unrealized losses, realized losses must be reported on tax returns and can affect your taxable income by lowering it.

That's good for tax purposes since it might offset realized gains from other investments. However, once a loss is realized, there's no chance of recovery from that specific investment unless the investor decides to repurchase the stock.

The decision to realize a loss or continue holding an investment depends on your financial goals, risk tolerance, and overall market outlook. While unrealized losses may recover over time if the stock price rebounds, realized losses provide certainty and potential tax benefits. However, they eliminate the possibility of gaining from the stock recovering afterward.

Short Selling: Profiting From Stock Declines

Short selling is a trading strategy where investors bet on the decline of a stock's price. It involves borrowing shares of a stock from a broker and selling them immediately at the market price. The short seller aims to buy back the shares later at a lower price, return them to the broker, and pocket the difference.

Here are the steps in how short sellers profit:

1. Borrow and sell: The short seller borrows shares of a stock and sells them at the market price. For example, if they borrow and sell the stock at $50 per share, they receive $50.
2. Price declines: If the stock price drops, as the short seller expects, they can buy the shares back at the lower price.
3. Buy back and return: If the price falls to $30, the investor can buy back the shares at this new, lower price. They repurchase the shares at the reduced price ($30 in this case) and return them to the broker. The profit is the difference between the selling and buying prices, minus any fees or interest on the borrowed shares.

However, if a stock price rises instead of falling, the potential losses for short sellers are unlimited, since they would have to buy the shares back at a much higher price.

Impact of Short Selling on Other Shareholders

Short selling can have both direct and indirect effects on regular long investors. When investors take short positions, they are essentially betting that a stock’s price will fall. As a result, significant short-selling activity can create downward pressure on the stock price, negatively affecting long-term investors holding the stock.

However, short selling can also benefit long investors in certain scenarios. Short sellers often help expose overvalued stocks or companies with questionable fundamentals, which could prevent long investors from holding onto a poor investment for too long.

In addition, when short sellers eventually cover their positions by buying back shares, this can create upward momentum in the stock price, potentially leading to a price recovery that benefits long-term shareholders.

The Stock Market is Not a Zero-Sum Game

Unlike options trading, where another's loss directly offsets one party's gain, the stock market is not a zero-sum game. In stock investing, many investors can benefit from a company's growth and success.

One exception is options trading. When an investor buys a call option on stock XYZ with a strike price of $50 for $5, they're betting the stock price will rise above $55 (strike price plus premium). If the stock reaches $60, the option buyer profits $5 per share, while the option seller loses the same amount. This direct correlation between profit and loss defines something as a zero-sum game.

The stock market operates differently. When a company performs well and its stock price increases, all shareholders benefit without directly causing losses to others—the rising tide lifts all boats. For instance, if Company ABC's stock rises from $100 to $150, every shareholder sees their investment value increase. This is quintessential to what market proponents call "value creation."

In addition, stocks can generate value through dividends and buybacks, further distinguishing them from zero-sum investments. When a company pays dividends, it distributes profits to shareholders without necessarily reducing the value of others' holdings. Similarly, stock buybacks can increase the value of remaining shares without directly disadvantaging any particular group of investors.

However, while the stock market isn't zero-sum in the long term, short-term trading and speculation can sometimes resemble zero-sum activities. Day or high-frequency traders might engage in transactions where one party's gain more closely mirrors another's loss. However, these activities are a small fraction of the overall stock market.

Market Crashes

Stock market crashes provide stark examples of how massive value can seemingly disappear from the market in a short period. Two of the most notable crashes in U.S. history—the 1929 crash and the 2008 financial crisis—illustrate how stocks aren't a zero-sum game in the other direction either: stock price drops destroy value without anyone necessarily gaining.

The stock market crash of 1929 marked the beginning of the Great Depression. On Oct. 29, 1929, known as Black Tuesday, the stock market lost almost 13% of its value in a single day. Over the following weeks and months, stock prices continued to plummet, leading to a total loss of about $30 billion in market value—over $400 billion today when adjusted for inflation.

This catastrophic decline was fueled by rampant speculation, overleveraging, and a lack of regulatory oversight. As stock prices fell, investor confidence evaporated, leading to panic selling. By 1932, the Dow Jones Industrial Average had dropped almost 90% from its peak in 1929. The repercussions were felt throughout the economy: businesses failed, banks collapsed, and unemployment soared to around 25%.

Fast forward to 2008, when the global financial crisis began with a sharp decline in housing prices and widespread defaults on subprime mortgages. As financial institutions became increasingly exposed to these toxic assets, confidence in the banking system eroded.

In September 2008, Lehman Brothers filed for bankruptcy, marking a pivotal moment that sent shock waves through financial markets worldwide. The S&P 500 index fell from its peak in October 2007 to its trough in March 2009. During this period, an estimated $17 trillion in household wealth evaporated because of falling stock prices and declining home values.

The crisis resulted in severe economic consequences: unemployment peaked at around 10%, millions lost their homes and consumer spending plummeted, causing massive ripple effects in just about every part of the economy. The government intervened with unprecedented measures such as the Troubled Asset Relief Program and aggressive monetary policies, including quantitative easing, to stabilize the economy.

The Bottom Line

When stock prices drop, the perceived disappearance of money is primarily a result of changing investor perceptions and market dynamics rather than an actual loss of capital. A decline in stock prices indicates a shift in supply and demand, often driven by negative sentiment or disappointing news, leading to more sellers than buyers.

This creates the illusion that money has vanished. However, it simply reflects reduced market capitalization because of lower investor demand. The "lost" value isn't transferred to anyone but represents a collective reassessment of the company's worth.

Understanding this concept is crucial for navigating the often turbulent waters of the stock market. Investors should remember that unrealized losses only become real if shares are sold at a lower price.