When You Buy a Stock, Where Does the Money Go?
Even some of the most basic questions about the markets are important as it pertains to understanding them, to get to kinow the mechanics involved in buying and selling stocks.
When you fund a brokerage account and execute a trade, you tie up a certain amount of your money as collateral. As such, where does your money go when you buy a stock (or another financial asset)?
The short answer is that when you buy a stock your money goes to the seller via an intermediary (the broker).
The seller of the stock is likely another trader or investor, but it could be any entity that transacts in stocks.
The intermediary (the broker) simply facilitates the trade and might charge a commission for doing so.
With online brokers and trading apps, it can seem like trading is just a game with random numbers on a screen. But answering some of these questions can give you a better idea of what goes on under the hood when you buy and sell stocks.
Let’s start with some basics.
What are stocks?
Stocks provide ownership in a company.
When you buy a stock you share in the profit-making capacity of a company. You effectively own a piece of the company and you receive profits commensurate with your percentage of ownership.
For example, buying a single share of a company might give you 0.0001% ownership in that business and therefore you’d be entitled to 0.0001% of the earnings (profits) of that company.
As with any investment, there is always risk associated with buying stocks. If the company goes bankrupt then you can lose your entire investment. However, in well-run companies, this is a rare event.
Generally speaking, stocks provide a relatively stable way to invest in a company and share in its success.
If you purchase a stock as part of a company’s IPO (which stands for Initial Public Offering), then the money goes indirectly (via an investment bank that facilitates the transaction) to the company.
For companies, issuing stock to the public is a good way to raise capital. This helps them fund growth for new workers, new R&D, more capital investment, and so on.
Why is it a good idea to own stocks?
There are a few reasons why you might want to own stocks:
1) You think the company is a good investment and will do well in the future.
2) You want to share in the profits of a company through dividends.
Not all stocks pay a dividend. Those that do pay dividends usually pay monthly, quarterly, semi-annually, or annually, with quarterly being most common.
Dividends are payments made to shareholders usually from the company’s profit. If a company is not at least earning its dividend in profits, the dividend is at risk of being cut. This usually causes a company’s share price to be hit significantly.
3) You want to buy low and sell high (or vice versa if shorting). In other words, if you tend to “speculate”, which is the process associated with trying to sell an asset at a higher price when you’re “long” and buy at a lower price when you’re “short”.
4) You want to use stocks as a way to hedge your other investments. For example, if you own a bunch of stocks in different companies and one of them does poorly, owning stocks in other companies can help offset some of those losses, or at least make that loss not as bad if you were heavily concentrated in it.
This is known as diversification and can lower your overall portfolio volatility and may lead to better risk-adjusted returns versus being heavily concentrated.
5) You want to provide funding to a company so it can grow (through an IPO) and share in its profits over time.
How does the stock market work?
The stock market is a collection of different markets where stocks are traded.
There are a few different types of stock markets, but the most common ones are the primary market and the secondary market.
The primary market is where stocks are first sold to investors. IPOs (Initial Public Offerings) happen on the primary market.
The secondary market is where stocks are traded after they’ve been initially sold on the primary market. The secondary market is where most of the trading volume happens.
The two main types of capitals markets, which are the equity market and the debt market.
The equity market is where stocks are traded. The debt market is where bonds (a form of debt IOUs) are traded. Stocks and bonds are both securities, but they are traded in different markets.
There are other types of markets, like the commodity market, but stocks and bonds are the most common types of securities that are traded.
When I buy a stock where does the money go?
With the basics out of the way, we can look at where your money goes when you decide to trade stocks or invest in them.
When companies first issue shares, they do so through an IPO. Once the shares of stock are available on the market, investors can buy or sell them.
Then they enter what’s called the secondary market where traders are free to buy and sell them to each other on an exchange.
When you buy stock on the secondary market – your money goes to another investor who is selling their shares.
This cash is made available instantly for the seller.
However, in reality, trade settlement is not instant. The cash is made available because of credit agreements that occur behind the scenes between traders, brokers, and clearinghouses.
This was an issue that came to the forefront during the Gamestop and AMC “meme stock” rally in early 2021.
And when you decide to sell your shares, you’ll receive cash from a buyer. This comes via the intermediary, which is your broker.
What does the money go when the value of a stock falls?
The price of anything is the money and credit spent on it divided by the quantity.
So if there’s less money and credit spent on these things, holding the quantity constant, then the price goes down.
Likewise, if you hold spending constant and lower the quantity, price will rise as well (this is why share buybacks are bullish for stocks, holding all else equal).
When a stock is sold, the money is converted to cash, which can then be used to buy something else.
How much is actual wealth destruction?
Typically very little.
Capital circulates more than it’s destroyed.
People can use the money they got from selling their stocks to buy other stocks, other assets in different asset classes (which can be in different countries and different currencies, which in turn makes those assets and those currencies go up, holding all else equal), they can keep it as cash, or they can spend it in the real economy on goods and services.
However, there can be cases when there is actual wealth destruction.
For example, when a company releases an earnings report that comes in lower than discounted expectations, the price of the stock will typically fall.
That is, the earning potential of the company isn’t what people thought it was. So they decide to sell the stock.
And if there are too many sellers relative to buyers, the price will fall.
This is because sellers won’t continue to find buyers at the currently marked price. Buyers will lower their bid prices. Bid-ask spreads often widen.
And once there’s more selling than buying at a given price, the price will fall until there are more bids from buyers, and so on.
This selling goes on until the market gets back into an equilibrium. This is the point where buying and selling match.
In extreme cases, such as market wipeouts (commonly due to war, revolution, and sometimes debt crises), exposures of fraud, and so on, buyers can (and sometimes do) literally all but disappear.
When everybody wants to sell and there are no willing buyers, a stock or asset will be zeroed.
In certain cases, an asset can go to negative prices when people need to be paid to own an asset. Commodities can apply (it’s happened in oil and electricity), but stocks have a bottom limit of $0.
In this case, there is a lot of wealth destruction. An asset they thought was worth something turns out to not be worth anything at all.
If a company doesn’t earn money (its revenue isn’t above its expenses) and its liabilities are above its assets and they will never be paid with earnings from the business, then a company doesn’t have any value if that’s the perpetual state of it.
Is the stock market a zero-sum game?
Over time, the stock market is not a zero-sum game of buying and selling because companies earn profits and these are distributed back to shareholders.
The stock market is a great mechanism for allowing people to:
- exchange their savings to fund companies…
- who innovate and create and produce more in resources than they consume…
- which benefits the company and…
- benefits the trader or investor in terms of a higher stock price and/or dividends and distributions paid back to them.
But the basic oversimplified answer to “what happens to my money when the value of a stock falls” is that the entity who sold you the stock has it and it fell in price because of supply and demand and the money is “gone” (until if and when the stock rises again or you make it up through the company paying dividends and distributions).
What all is involved with stock ownership?
Most stocks are in the form of common stock. Common stock usually comes with voting rights and often includes dividends.
You share in the company’s profits and any applicable losses and bear those risks.
Stocks can also be owned through collective vehicles that include many stocks, such as ETFs or mutual funds. These offer diversification since you’re spread out among many companies.
But the basic idea behind stocks is that you can think of it as owning a piece of the company.
Conclusion
Typically, when an individual buys or sells a share of common stock on the open market, their money goes to or from the broker-dealer through whom the trade was executed.
The broker-dealer then has the money and is responsible for holding and safeguarding it.
Making money in the markets is not easy. You really need to have a strategy that makes good economic sense, like any business.
When you trade stocks, you are essentially buying and selling pieces of ownership in companies. The price of a stock is what somebody is willing to pay for it at any given moment.
The goal when trading is to buy low and sell high. You make a profit when the price you sell it at is higher than the price you bought it.