Confusing Real Wealth And Paper Wealth

wealthymattersOften people see the SENSEX/NIFTY values,property prices etc. and the GDP as one and the same or as proxies for each other.After all if the economy is good, the GDP and stock indices , property prices etc. are expected to rise.By doing so people are confusing real wealth and paper wealth.This confusion  especially happens to people who own stocks.And today an increasing number of people  own stocks,if not directly than through mutual funds.Incidentally, even debt mutual funds might have an equity component.In the insurance front, not just ULIPS but also the bonuses in traditional products are dependent on stock market returns.Blended funds in child plans and pensions also have an equity component.So today, many people with no intention of dabbling in stocks still have an equity exposure and are prone to confusing the rise in paper wealth due to valuation gains with a rise in real wealth.

In fact there is widespread confusion between creating  real economic wealth and financial paper wealth.This is an obstacle to understanding the forces that drive the creation of prosperity.Sustained economic growth is achieved via the creation of real wealth.For example, mining more gold,building new factories,putting up new homes etc. Few financial transactions create economic wealth. A financial transaction, for example the buying of gold,real-estate, listed shares or in-circulation bonds is not the creation of new and real wealth. It is the transfer of wealth (an investment opportunity cost) from those who executed the transaction at an unfavorable time to the opposite party who bought/sold at a time where the asset was mispriced in their favor.

Let’s use ITC shares as an example. When you buy ITC shares from your broker, ITC doesn’t get the money. The seller of the shares receives the proceeds. Post-transaction there are only two scenarios. The shares will go up or down. If they go up the buyer is profiting at the expense of the seller (who should have held). Wealth has not been created, all things being equal. Likewise if the shares fall, the excess profit above fair economic value received by the seller is offset by the buyer’s losses. If there are more buyers than sellers then the price will rise,(i.e.asset price inflation) but new real wealth is not being created. It’s just paper wealth. Nominal paper wealth, unless supported by real assets of similar economic value, is always vulnerable to collapse.

Shares do not represent real wealth. Rather they are a claim on the profits that it is believed the underlying companies are likely to make in the future. If expectations change, the value of the portfolio can easily slump.The confusion between real wealth and paper wealth explains why many of the High Beta Rich saw their fortunes plummet from 2008 onwards.(For more about the High Beta Rich )

Now add into this environment banks who lend consumers, investors and institutions cash, some of which is used in the purchase of paper assets. Buying increases, asset prices are inflated, bubbles are generated and the only winners are the few who through luck or rare judgment sell their assets at the inflated (incorrect) prices.Of course some financial transactions, a minority, can potentially create wealth. When a financial transaction gives entrepreneurs or companies additional cash and that cash develops a new product, a new drug or an asset that produces a new revenue stream, then real economic wealth is created. But most financial transactions do not. Successful stockbrokers, who trade in listed securities buying and selling assets at the optimum time, are therefore not creating new economic wealth. They are reallocating society’s existing wealth from shareholders who buy or sell at the wrong time to their clients.

About Keerthika Singaravel

9 Responses to Confusing Real Wealth And Paper Wealth

  1. zap197842 says:

    useful for sure

  2. Sara says:

    Very insightful.

  3. Pingback: Confusing Real Wealth And Paper Wealth « Wealthymatters | Wealth Building Tips

  4. I almost understand some of this now

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