I’m sure by now you’ve heard about GameStop. The saga reads like a made-for-TV morality tale about how the little guys stuck it to the big bad rich Wall Street hedge fund investors through what’s called a “short squeeze.” But the story has not yet played out to its end, and there are valuable lessons that everyone should be gleaning from it.
What happened in brief is that a number of hedge fund managers saw GameStop as a company with poor growth prospects and a stock price in continuing decline. Consequently, they shorted its stock, which involves borrowing a lot of shares and selling them with the expectation of buying them back at a much lower price in the future, thereby making a lot of money.
Enter Keith Gill, an investor on a social media investment site who managed to convince a lot of small investors to buy up GameStop stock. Ordinarily it would take a serious number of investors to buy enough shares to materially drive up a stock’s price. In this case, they were aided by three factors: (1) social media and crowdfunding reaching a large number of players; (2) the use of stock options enabling the purchase of many shares with only a small down payment; and (3) the high level of “naked” short selling by many hedge funds, which involves selling shares without first borrowing them.
This high-risk strategy forced those short sellers to buy more and more shares at higher and higher prices to cover their positions as GameStop’s price rose, adding more fuel to the stock’s price inflation. The result was a meteoric rise in a very short period of time.
Is the system rigged?
The first question that’s on many people’s minds is whether this demonstrates that the stock market is rigged. The simple answer is that it is no more rigged than the housing market. Or the oil and gas market.
When you have a limited supply of something and demand goes up, the price will necessarily follow. That is Capitalism Economics 101. And short selling and options buying – which some might perceive as the evil enablers of GameStop’s volatility – are also useful tools for reducing market risk via hedging (which ironically is something so-called hedge funds rarely do).
Regulators might ultimately step in over the coming months and tweak some trading rules to ensure more orderly market activity. But there’s nothing underhanded going on unless Gill can be found to have lied about the stock in order to have gotten other investors to drive up its price so that he could subsequently sell his shares at a huge profit. That’s known as “pump and dump,” and it’s illegal. I haven’t seen any evidence of that so far.
The next lesson is for all those participating GameStop investors who are now collectively holding a lot of GameStop stock. You may have made a lot of money on paper, but you won’t be able to realize those gains until you sell your shares or options. If everyone decides to do that at around the same time, a number of you are likely to find yourselves trying to sell while GameStop’s price is in free fall. In that circumstance, you might be lucky just to break even before getting out.
What’s the solution? Sell before everybody else does. But good luck trying to time that.
Is there a lesson for long-term investors who are simply trying to grow their savings enough to maximize the likelihood that they don’t run out of money before they pass away? Yes, there is. Ignore what’s happening with GameStop, Tesla, silver (the metal) and any other individual investment that happens to be trending on social media. Stick to a well-diversified game plan. You won’t become rich. But you won’t become poor, either.