Thoughts on the Latest “Easy Money” Scheme

As the world is now acutely aware, much of the media focus for the past week or so has been on GameStop, a money-losing retailer that sells video games. They were (until now) a little-known mall-based company whose business model looks and feels a lot like Blockbuster. Those old enough will recall exactly what happened to Blockbuster – both to its stores and its stockholders. In this case, though, shares of GameStop exploded to truly stratospheric levels, suddenly giving this small-ish company a market value that would rank somewhere in the middle of the pack of the S&P 500.

By now, the story of GameStop and other stocks (such as BlackBerry and AMC Entertainment) should be familiar to anyone who has opened a browser or tuned in to any news show. We won’t rehash all the details here, but the basic idea is that a bunch of individual “investors” have openly banded together and decided to buy GameStop stock or buy call options on the stock. They did so not because they thought that the stock was worth more than the then-current price or even that the company’s growth prospects were bright.  Rather, it was to try and force others to buy the stock at an even higher price. There’s nothing inherently wrong with that – “momentum” investing is by its nature centered on the idea that if you buy a stock for $X, someone else will come along and buy that same stock for more than $X.

But here’s where it gets really interesting. As it happens, many hedge funds and other large market players had made massive bets that GameStop would actually decline in value, principally because of the challenges to its business model and its failure to pivot to embrace online gaming. They did that by “shorting” the stock, which means they borrowed the shares from others and sold them on the open market.  So they sold before they bought — a little counterintuitive, but it happens a lot and actually contributes to well-functioning markets.

Eventually, every short seller needs to buy the stock back to close out their trade and (hopefully) book a profit. And when that closing transaction is a purchase, well there’s literally no limit to the price at which that trade might happen. When you’re selling, the lowest possible price is zero, but when you’re buying, the sky is the limit.

That tends to make folks nervous, and the higher the price goes, the more the short seller is “squeezed.” They may eventually need to throw in the towel. And if the short seller doesn’t have enough capital to make that buy, they’ve got a real problem.

As a result of the GameStop short squeeze, a couple of big names on Wall Street were in serious trouble to the tune of billions of dollars and needed rescue from other market players.  One prominent hedge fund was reportedly down over 50% in January alone.

Essentially, these “little guys” got together and stuck it to The Man. There’s more to it than that when you start considering how the options markets work and other pieces of the puzzle, but that’s the gist of what’s been happening. The subreddit gang beat the experts at their own game.

It’s not our place to comment on whether all of this is right or wrong, or if anything illegal, or even immoral transpired. And we don’t have a clue what regulatory, trading or other changes might come about as a result. But it sure is fascinating on so many levels.

This brings us to the real point of this post: What does it mean to our clients and friends? The short answer: Not much. We’ve fielded some great questions about how to make sense of it all, and a few clients have even expressed interest in participating somehow in the meteoric rise of GameStop or some of the other companies that have been caught up in this.

As with many “trendy” investment ideas throughout the years (like internet stocks, or more recently Bitcoin and Tesla), we believe a true long-term investor is best served simply viewing from the sidelines. When examining these investments, it’s best to consider whether they are necessary to help us meet our goals.  While the potential upside is enticing, the realistic probability of a large decline cannot be ignored.

So why are we even talking about this? While making these types of investments is not “what we do,” we know that you are watching. And that’s ok! If we are being honest, how can anyone ignore it altogether? The GameStop story is now part of mainstream media. There was even a pretty funny skit about it on Saturday Night Live the other night – a sure sign that something is firmly in our collective consciousness.

One thing does seem to be pretty clear; many of the old barriers to entry for investors (access to information, ability to use trading platforms, and high commissions) have been knocked down, and faster-paced markets are the new normal. Zero-commission trading alone has had an enormous impact on the trading habits of individuals and is a key piece of the current GameStop saga.

We understand that despite our best advice about long-term investing, not chasing fads, not timing the market, and other well-worn but prudent concepts, some of our clients may want to dabble (or have already done so). So here’s what we think about that:

  • Think of this as gambling and not investing because that’s what it is.
  • Like at any casino, do not gamble more than you can afford to lose. In fact, you should assume that you will eventually lose 100% of what you gamble.
  • Know that playing with options is especially risky. While the inherent leverage in options can be seductive, to be successful, these strategies require that you be right about both the premise and the timing. Getting one right without the other can still result in the loss of your entire position.
  • Do not confuse success with expertise. They’re entirely different. (Please read that again.)
  • While there’s an interesting game afoot at the moment, eventually the fundamentals of a company matter. You don’t want to be caught on the wrong side of the trade when that inevitably occurs.

So dabble if you must, even if we’d prefer that you not. And remember that at SWP, we remain focused on one  thing – helping our clients achieve their goals. We are all long-term investors and we don’t trade to make a quick dollar. Aligning your financial plan and your portfolio with your goals and your personal situation is the key to success. Markets may be moving faster than ever, and trendy investments will keep hitting the airwaves and the CNBC ticker, but we won’t let that push our clients off course.

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