What Happens When the Stock Price Drops?

I just wrote a A Simple Guide to Financial Freedom based on my experiences with Financial Freedom. Consider giving it a read if you are interested in this topic.

The stock market is a volatile place. When you decide to join you have to accept this. But what really happens to your investments when the stock price drops?

Before we answer that question, let’s zoom out a bit and focus on another one first: What is our goal when investing in stocks?

For me, it is to build up wealth.

Wealth is not money. Money is not wealth. The definition of wealth can vary from person to person but I’ll go with one I like from Naval:

Wealth is having assets that earn while you sleep.

That’s what I want. And you can now see why money is not that. Having a lot of cash lying around will not bring any income unless you do something with it.

If we take the full quote we may be able to better understand money also:

Seek wealth, not money or status. Wealth is having assets that earn while you sleep. Money is how we transfer time and wealth. Status is your place in the social hierarchy.

Let’s take an example. A house can be wealth. You can either live in it or you can earn while you sleep by renting it out. If money were to disappear from the world tomorrow, a house would still be valuable.

If I have a house in Denmark and I want to move to the US, that would be pretty difficult though. I could attempt to find someone to swap houses with. Or at least trade with someone for something. But it would be a challenge to find a good trade. Transferring wealth, like a house, is difficult — so we invented money.

Money is how we transfer wealth.

A company is quite similar to a house when it comes to wealth. You can’t live in it but it can earn money while you do other things. And many companies have physical assets that are valuable. Even fully online companies have valuable assets — usually their software.

When the stock (or house) price falls, you still own the same assets as you did before. Your house is still your house and your company assets are still the same company assets. The only thing that has changed is perception — the price people are willing to pay for what you have.

Nothing really happens to your wealth. At least as long as you don’t have to sell right now. If your goal is to build up wealth this is comforting.

Now, the new valuation put on your assets may be more accurate than what it was before. But it may also be totally out of wack. The decline may be temporary, it may be caused by bigger things in the world, or it may really signal a business in decline.

If you have the skills you may be able to create your own valuation and determine what your assets are really worth. More likely, you should just invest in an index fund to capture the market average.

Through this lens, market volatility is less scary. Dips in the market mean cheaper assets for you to scoop up. Increases mean your relative wealth increases. But through the daily ups and downs, your assets remain the same.

Ignore the bumps on your financial journey. Build up wealth. That is what matters.