Over a long enough time horizon, the stock market goes up. That’s why it’s one of the best ways to build wealth – that’s why it’s the preferred investment for so many Americans.
It makes up the bulk of my investments – a simple portfolio of index funds, the majority of which is invested in the S&P 500 index.
That’s why when the stock market goes up, everyone is happy! You now have more wealth than you had before – that’s a good thing.
But there are ways to make money when the stock market goes down. There are people who build wealth even in times of economic difficulty.
While you may not be in a position to take advantage of these moments, it’s still important to understand who these folks are:
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Short sellers are people who hold positions that go up in value when the underlying security goes down in value.
The best example of this is when you short sell a stock. This is when you borrow shares from someone else, sell them on the market, and then buy them back later. The idea is that you borrow the shares when they are higher in value, sell them, and then buy them back lower when it’s time to return the shares.
The risk is that the stock goes up in value or doesn’t fall enough in value to cover the cost of borrowing.
Short selling a stock is just the basics of this investing strategy.
If you’ve ever seen The Big Short, you’ll recall that there are other ways you can short the market. A good example of this is if you look at inverse ETFs. These are ETFs that invest in securities that are negatively correlated with the stock market. They go down when the market goes up and vice versa. Those securities get pretty complicated so I won’t get into it now but the bigger players in the market use those instruments.
Put Option Buyers
A put option is a contract where the holder has the right, but not the obligation, to sell shares at a certain price. When you buy this option, you are buying the right to sell shares to another investor at a certain price. The price you pay for the contract is known as the premium.
This contract is itself a security and has value. If the underlying stock falls in price, the put option contract will increase in value because it allows the holder to sell their shares at a price greater than on the open market. If the stock price goes up, the value of the put option goes to $0 since no one would want to buy it.
You can make money by exercising the option and selling your shares or you can sell the options contract itself.
This is a category that you, as an individual, will not be able to use but still useful to understand.
There are a category of market participants known as “market makers.” They provide liquidity in the stock market by buying and selling large blocks of shares on the market. They use advanced trading algorithms to identify small price differences (like bid-ask spreads) and take advantage of those.
They play an important role in the market but they tend to make money in times of high volatility, which also tend to correspond with times when the market is falling.
I’d also through stock brokers into this category too – they make money either from sales commissions or selling order flow.
Long Term Investors
The best way to take advantage of a falling market is being an investor with a long time horizon.
There’s a popular saying in investing – “You make when you buy, not when you sell.” Your purchase price of an asset plays a very big role in how much profit you’ll gain.
You might say “Duh, of course! Buy low, sell high!”
But what is low? What is high? It’s impossible to know because it’s all relative. Even if we use objective measures, like the CAPE index, we don’t know how long that value can remain high.
But if you’re a long term investor who makes regular investments in the stock market, a falling market is an opportunity to invest in the stock market when it is running a sale.
You won’t make money while the stock market is falling but you’ll make it when it recovers and it’s time for you to sell.
So, Where Does The Money Go?
After you read the list above and realize how few people “make” money in a falling market, you might be wondering – what happens when the stock market goes down and all that money “disappears?”
Where did that money go?
Who gains when the stock market loses billions of dollars?
The answer is simple – the money wasn’t there to begin with.
When you look up a stock price, it’s just a record of the very last transaction. Someone bought at least one share at that published price.
When you look up the price of Apple stock, what you see is the price of the last sale. That’s all that is.
It’s what the market agreed it was worth at that moment in time.
As a result of that one transaction, all shares are “valued” at that number and we get stories about how the market cap of Apple is trillions of dollars (which is true). But if everyone who owned shares wanted to sell them all at once, the price would go down. And not for the price that you see on the quote.
But this also means that very few people paid that much for the stock. Some paid more, some paid less. But on the whole, the total amount of cash that left “circulation” to buy those shares is much lower than the market cap.
The reality is that the money wasn’t there in the first place. People have money invested in companies but the total sum is not what you see on the ticker. People lose money but many of them lose money they never had in their pocket.
If you just read all that and thought “that was pretty obvious but why didn’t I realize that?” – it’s because of how the media talks about it. When the market falls, they say “X billions of wealth just got erased!” or “company X lost billions in value!” because those headlines grab your attention. It’s just marketing and attention seeking, it’s not reality.
It’s taken me many years to learn that lesson and my mom knew it decades ago when she said my comic books, which are still in my basement today!, wouldn’t be worth anything. 😂