The story of recent market craziness came to the fore with the episode of GameStop. The series of events speaks to many points, not the least of which is the importance of understanding what you are doing before you take on any complex venture. My corny analogy is that a chisel in the hands of a master craftsman can create beautiful furniture; but a novice can simply cut themselves badly.
All the details are beyond the scope of this article, so here is a short discussion. GameStop is a video-game retailer that, until very recently, possessed a stock that interested almost nobody. Rather than profit from sound business, GameStop’s performance derived from investor behavior. A recent small increase in stock value attracted short sellers, largely hedge funds, who believed that an unprofitable, shrinking company with an out of date product did not deserve that value.
When GameStop appeared on the list of most-shorted stocks, a social media campaign began on Reddit, which was nothing more than a gossip session. The pitch was that if retail investors purchased enough GameStop stock, they could profit by creating a “short squeeze,” while also punishing the hedge funds. Some have chosen to portray the events as a morality play, with everyday investors banding together to punish Wall Street sharks.
Actually the story is really about what happens when greed and gossip disregard risk. Be careful that you understand the true rules of the actions you take. In this case, inevitably the stock has returned to its price before the excitement.
The subsequent results of this episode are interesting. First of all, the markets actually worked; maybe you did not like the result, but they functioned mechanically the way they are supposed to.
The participants did not fare as well. It remains to be seen whether the regulatory system works to a high standard as it analyzes what happened.
Apparently there was some illegal behavior. One Reddit participant, Roaring Kitty, was actually a licensed securities representative. The recent lawsuit against him alleges he used social media to manipulate the markets, to prearrange trades with others, and undermined the integrity of GameStop and the capital markets. Quite a charge. So much for morality.
Some people, new to investing, actually borrowed to invest and then lost big. Others took complicated positions with options and now face huge tax results.
Hedge funds, which were investing money for their clients, set up very high risk positions. They suffered crushing losses, or rather their clients did. Had they fully informed their clients about the risks? Who bears the responsibility for the fiduciary duty to clients?
One financial company with a large stake in the over-extended hedge funds, and therefore their potential losses, also owns Robinhood brokerage. The risk of the moment was related to investors buying more shares of GameStop. Suddenly Robinhood said they would not accept any more orders to buy GameStop because they wanted to protect their customers. Really?! They are being investigated and sued for failing to follow SEC rules.
As the investigations develop, the question arises about the role of social media and its influence. Perhaps all of us should be more cautious about accepting what we see on any social media platform.
This is probably a good time to mention that investing and gambling are not the same thing. As we all try to have perspective on these events, it is easy to view the stories of market speculation as cautionary tales for individual investors. We can also view the events as an opportunity to welcome a new group of investors to the market: those who have been drawn in by all the high-stakes action, and yet may want a consistent, long-term investment solution that does not cause them distress.
If you are not comfortable betting your life savings on a long shot, the good news is that you need not fret over finding the next flashy stock to win in the stock market. Concentrating your whole investment on one or two companies means the stakes are high enough to expose you to unnecessary risk. Even if you manage to land a few big winners, research has found that good luck is unlikely to repeat throughout a lifetime of investing. For every individual who got in and out of a hot stock at the right time, there is another who bought or sold at the wrong time. If you treat the market like a casino, not only do you have to pick the right stock, but also the right moment.
You are better served using the whole market and its collective opportunities than on individual stocks, through a low-cost, highly diversified portfolio. Then let time and compounding do their work. Compounding is the investor’s best friend: if an investment grows at a rate of 10% a year, the result is a dollar invested has doubled every seven years. As a point of reference, the S&P 500 has grown at rate of 10.26% since 1926, though the path is never smooth.
Having a solid investment plan is key. Then use consistently. Markets have never been so accessible, and information has never been so widely available. Despite the fact that stories of stock market gambling keep making the news, many investors have managed to enjoy growth in their investments using low-cost, highly diversified strategies.
If you intend to be a long-term investor, commit to a long-term strategy that considers your own personal goals, situation, and risk tolerance. Remember that although the US stock market has returned about 10% a year on average, returns for individual companies and individual years can vary wildly. Look at the big picture. A huge win on a stock bet today is useless if you lose it tomorrow. Investing is a lifelong journey. Making money slowly is much better and reliable than making and then losing money quickly.