Price as a Portfolio Value Ratio

Spending money just makes it someone else's problem

Did you ever stop and think about what happens when you spend money?

This article is building on a topic I’ve mentioned previously, the misleading terminology around money “flowing into” an asset class. I’m going to approach another aspect of this misconception that I think will be helpful in understanding the price movements of assets in general. It also has implications for the way price inflation happens.

Spending money, if you stop and think about it, only transfers that money to someone else. The money is still there, its quantity hasn’t changed, but it’s just in a different person’s bank account or wallet now. That’s fundamentally why money can’t “flow into” an asset. If you buy an asset, that money you spent is still available to spend, just by someone else rather than by you. It’s not somehow sitting there inside the stock or bond or real estate, waiting for you to sell your asset so it can emerge back into the financial landscape and be spent again.

So lets create a very simple mental model of this process and try to understand how asset prices change.

Lets imagine there are only two financial assets you can own: money, or Apple stock. And let’s imagine for this exercise that there are only two people in the world who own assets, you and Bob. Imagine that there are 10 shares of Apple stock in existence, and $1,000 in existence. You hold 5 shares of Apple stock and $500, and Bob also has 5 shares of Apple stock and $500. The current price of Apple stock is $100 per share, so you and Bob each have $500 of your net worth in Apple stock, and $500 in cash. So 50% cash, 50% stocks.

Now imagine that you and Bob are watching CNBC one day, and a financial guru advises everyone to hold 75% of their wealth in stocks, and 25% in cash. You and Bob both see the recommendation and immediately decide to adjust your portfolio allocation. So you go to Bob and say “I want to buy some of your Apple stock, would you sell me some for $110 a share?” Bob of course also wants more Apple stock, so he says “No, I don’t want to sell any right now, but can I buy some from you for $120 a share?” Of course that doesn’t work for you, so in an effort to increase your portfolio allocation to Apple stock, you raise your offer to $130 a share. Bob counters with a $140 offer, and so on. Finally, after a few minutes of increasing bids, you offer Bob $300 a share for some Apple stock. Bob says “No thanks, that’s okay, I don’t want to sell any, I’m good now. And with Apple stock at $300 a share, I don’t want to buy any more now either. I’m already 75% allocated to Apple stock just like that guru said.”

You stop and think for a minute and realize that at $300 a share, your 5 shares of Apple stock are now worth $1,500, while you still have $500 of cash. A perfect 75/25 allocation, exactly the ratio you wanted. Success! You and Bob both go home happy that you now have an ideally balanced portfolio.

There are a few things to notice here. One, the price of Apple stock tripled, and not a single dollar changed hands. No “money flows” occurred. Why did price rise? Because of a change in perceived relative value of money and Apple stock. Money went down in perceived value from an asset worth 50% of a portfolio, to an asset worth 25% of a portfolio. Apple stock did the inverse.

Second, money depreciated in value in relation to Apple stock. A hundred dollars went from being worth one share of Apple stock, to being worth one-third of a share of Apple stock. So your cash holdings lost value against Apple stock, in the same way inflation causes your dollar to buy fewer groceries today than it bought 5 years ago.

Now lets apply this model on a larger scale. Imagine all the money and assets held by every person in the US. In aggregate, they hold a certain number of dollars, and a certain number of shares of Apple stock. So what has to happen for Apple stock price to rise? Of course individual investors can adjust their portfolio allocation by buying and selling stock. Selling increases their cash balance, while lowering their Apple stock holdings. Buying does the inverse. In that way, individual investors can reach their personal desired ratio of cash to Apple stock. But for the market price to rise, there must be an overall aggregate desire to hold a higher percentage of Apple stock relative to cash. That will cause individual investors to bid higher and higher for shares of Apple stock until the market price reaches a new equilibrium with the constant quantity of dollars in people’s bank accounts.

The higher price is caused by the change in desired ratio of value held in Apple stock versus value held in cash. You can buy and sell on an individual level to achieve that balance. But since the money you spend when you buy goes to someone else’s bank account, the total quantity of money remains constant. That means price changes are the only way to reach equilibrium over the whole market.

So what would happen if we increase the money supply? Say, by creating trillions of new dollars and distributing them throughout the economy? Well, if everyone wants to maintain the same ratio of cash to Apple stock in their portfolio, the same percentage allocation, and there are now trillions of new dollars while the number of shares of Apple stock remained the same, that means the price of Apple stock needs to go up. And as individuals bid higher and higher on the market in an effort to rebalance their own portfolio, price will go up until a new equilibrium is reached.

Of course there are thousands of different publicly traded companies in the US, not to mention all the other asset classes people choose to invest in. But the same principle applies to the price of every one of those assets. Price changes are caused by an aggregate change in the desired ratio of that asset in the portfolio, or by a change in the quantity of dollars in existence. For some assets, the quantity of the asset might also change, say by a company issuing new stock or by new houses and apartments being built. This also changes the portfolio allocation ratio in aggregate, and can move prices the same way increasing or decreasing the money supply can move prices.

How does this apply to general price inflation? People typically have an ideal amount of cash they’d like to hold in savings, based on the need to cover regular bills and any unexpected expenses. Maybe it’s 3 months of living expenses. Maybe a different amount, it doesn’t matter. Say the increase in money supply happens, and trillions of new dollars enter people’s bank accounts. Now the person who wanted to hold 3 months of living expenses suddenly has 12 months. What happens now? Well, some people might decide they want to hold a bigger cash reserve. But that’s not the norm. Most people will spend that extra cash. Maybe on eating out more often, or an addition on the house, or a down payment on a new house, or a new car, or some new clothes, or a new watch, or whatever else you can imagine. Of course as you should realize by now, spending the money just moves it to someone else’s pocket, and overall the aggregate level of savings doesn’t change.

So how do we get back to equilibrium with people’s desired amount of cash savings? You can probably guess by now. People keep buying goods and services until the supply is overwhelmed, and then are willing to keep paying increasingly higher prices. As prices of restaurant meals and building materials and houses and cars and clothes and watches rise, the overall cost of living rises. As the cost of living rises, those bigger cash balances in people’s accounts become fewer and fewer months worth of living expenses. At some point, equilibrium is reached again, at a new higher cost of living.

Just for fun, let’s take it one step further. What happens as prices rise? Suppose you have 6 months of living expenses, but prices are rising steadily, and now you realize your savings are only worth 5 months of living expenses. You realize that your savings are rapidly losing value. And who wants to hold onto something that’s losing value? So you and everyone else across the economy simultaneously decide that you don’t want to hold as much of this rapidly inflating money. Maybe 2 months of savings would be okay.

So what happens as everyone decides to reduce their relative cash balance? They go spend the money somewhere, same as if the money supply had increased. What happens when everyone is trying to reduce their relative cash balance by spending money? Prices rise. And what happens when prices rise? People are incentivized to reduce the size of their cash savings. See the vicious loop? If the mentality that prices will continue to rise takes hold, and the cycle proceeds far enough, you end up with a hyperinflation like Weimar Germany. It got bad enough that employees were paid at noon so they could rush out over their lunch break to buy things before prices rose again. And middle aged bachelors would buy diapers if the store was sold out of everything else, simply because anything was better than holding any amount of rapidly depreciating money.

This is the hyperinflationary spiral central bankers have nightmares about. It’s the reason they continuously lie and gaslight the public about the reality of inflation. Because if the reality of continuously rising prices becomes general knowledge, and enough people act accordingly, the whole thing can spiral out of control.

We can also use a reverse example. Suppose Apple comes out with a new piece of amazing tech, and it looks like the company will do very well over the next decade. Suddenly millions of people decide they’d like to increase their allocation to Apple stock. As they rush into the market to buy, they must bid higher and higher prices, and Apple stock rises 20% in a week. Now imagine all the people who own Apple stock. If you’re one of them, and that part of your portfolio is up 20% this week, do you now want to increase or decrease you allocation to Apple? Some people will be ready to sell, but most tend to increase the allocation to something that’s performing well. So now millions more are looking to buy Apple stock. What happens as they rush into the market to increase their allocation? More price increases. See the cycle? That’s why the saying “markets can remain irrational longer than you can remain solvent” applies to stock price bubbles. The bubble can become a self-sustaining move, at least for a while.

I hope this has given you some fresh insight into how prices and markets move, and how human sentiment and money supply increases influence those outcomes. Finance is complex, but faulty and misleading terminology only muddies the waters further, making it almost impossible for people to understand what’s happening. If I’ve shed a little bit of light on a confusing topic, that’s a win in my book.