Those of you who know me might say I’m a little old-school. I grew up very modestly, I live pretty simply (as least I feel like I do), and I enjoy a lot of the simple pleasures in life. Every Saturday is date night with Jill. I love having breakfast with my girls on Saturdays at Mary Ellen’s Portugese Bakery. And I get a kick out of wrestling with our dog, Louie. Pretty simple, right?
Well, one thing I am not well-schooled in, however, is the use of social media. Sure, I have a Facebook page and a LinkedIn profile. I have even tried Twitter, too. But I’m not an avid user personally. So it’s no surprise that I really didn’t know much about this thing called “Reddit” until a couple of weeks ago. Maeve called me from college to ask me what my thoughts were about investing in GameStop, and if she should try it out. It seems she had been reading a lot about it on Reddit and it looked like those folks were making a killing in the market.
Not surprisingly, I have been reading a good deal about GameStop, so I was at least aware of Reddit’s involvement in driving up their stock price. And as a financial advisor, I’m also aware of just how risky the markets can be, especially when you’re dealing in alternative investment strategies like “shorting” a stock – which was at the center of the GameStop rage. Heck, my whole business model has been built around downside risk mitigation and why it is important. So, I used this opportunity as a teaching moment with Maeve to help her better understand the complexity of the markets and just how fickle they can be. So this week, I’d like to dig deeper into what GameStop can teach us about investing now, and in the future.
So just what happened? Well, to understand this, you need to be familiar with some investing basics. To start, know that a stock is valued in a variety of ways and is dependent on a number of factors. However, stock price itself is not indicative of a company’s performance or financials – although it can be – but is instead driven by supply and demand for the specific shares.
Case in point? GameStop has had poor performance over the past decade, alongside the growing digitalization of video games. So why has it gone up so much over the past week?
Well, a group of investors, mostly from the sub-reddit page r/WallStreetBets, identified that some hedge funds (mainly Melvin Capital Management) have been holding rather large short-selling positions on GameStop (Short-selling, to make a long story short, is essentially betting that a specific stock will fall in value over time). So, the individual retail investors then bought up just about all the available shares. Since there’s only a limited amount of shares, this action caused them to effectively control the shares available to the public and create an artificial demand, causing the price to skyrocket. Supply was short, so demand went up..
And as the stock price rose, fund managers were forced to buy more and more shares at ever-increasing prices to “cover their bets,” while individual investors continued to buy shares in hopes of continuing the momentum.
The opposing forces created a frenzy that sent the stock soaring far beyond the fundamental value of the company. As a result, from January 13 to January 28, 2021 the stock of GameStop skyrocketed by more than 2,200%. The stock price peaked on January 28 and lost almost 90% of its peak value over the next five trading days! All of this activity was essentially due to two primary groups of investors – professional managers of multi-billion dollar hedge funds, who took a calculated risk that GameStop would drop in price, and your average “Joes or Janes” who rallied behind these heavily shorted stocks.
Given how risky short sales are, why would someone engage in them? In this case, the hedge fund investors basically “borrowed” shares of GameStop and on margin from a brokerage firm and then turned around and sold the shares at the market price, with the expectation that the share prices would drop significantly by the time they had to return the shares to the lender. The idea is that they could then repurchase the shares at the lower price, return the shares, and pocket the difference, minus fees and interest of course.
But the strategy backfired this time. When GameStop share prices began to rise quickly, the hedge fund managers had to start buying shares at market prices in order to protect against future losses. These purchases helped drive share prices even higher — remember, supply and demand — which led to more purchases and even higher prices.
At various points during the peak trading activity, some brokerage firms actually stopped the trading of GameStop and other heavily shorted stocks. In fact, on February 2, when the price of GameStop was plunging, the NYSE suspended trading five times throughout the day. Amid cries of unfairness to the small investor, the restrictions actually helped protect investors from being overextended and suffering outsized losses amid extreme volatility.
Folks, what’s important to take away from all of this is that the market is a volatile beast and participating in alternative strategies – like short sales – is nothing but speculation. The only two things we have control over is risk and process. So, what is your risk budget and what is your process? When you’re preparing for your last day at work, risky investing involves wild swings that could endanger your retirement. Instead, stick with a solid retirement system, one that is built off a foundation of downside risk mitigation with a clearly defined risk budget and a proven process in place . . . it’s a much safer bet!
And as always – be vigilant and stay alert, because you deserve more!
Have a great week.
Jeff Cutter, CPA/PFS is President of Cutter Financial Group, LLC, an SEC Registered Investment Advisor with offices in Falmouth, Duxbury, Mansfield. Jeff can be reached at firstname.lastname@example.org.
This article is intended to provide general information. It is not intended to offer or deliver investment advice in any way. Information regarding investment services is provided solely to gain a better understanding of the subject of the article. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy will be profitable. Market data and other cited or linked-to content in this article is based on generally-available information and is believed to be reliable. Cutter Financial does not guarantee the performance of any investment or the accuracy of the information contained in this article. Cutter Financial will provide all prospective clients with a copy of Cutter Financial’s Form ADV 2A and applicable Form ADV 2Bs. Please contact us to request a free copy via .pdf or hardcopy. Insurance instruments offered through CutterInsure, Inc.