Timeless Takeaways from the GameStop Saga

Every so often, financial markets give us the chance to revisit important investing lessons. They are learned and relearned through different eras but can be modernized for current events.

The recent GameStop saga is one such episode.

Lesson 1: Short Selling Is Risky

The mania around GameStop shares probably wouldn’t have happened had several hedge funds not shorted them.

When a stock is sold short, a trader is making a bet that the price of the stock will fall. Short selling involves borrowing shares from a broker and then selling those borrowed shares. To close the short position, the trader later buys the same number of shares and returns them to the lender.

The short seller’s profit or loss on each share is the difference between the price at which the shares were initially sold and the price at which they were later purchased and returned to the lender.

Short selling can be a lucrative strategy for speculators who correctly anticipate a stock’s decline. However, anyone contemplating shorting a stock must remember that the risk/reward trade-off is heavily skewed.

A short seller’s maximum potential gain is 100%, and that’s only if the stock price falls to $0. Meanwhile, a short seller’s potential loss is unlimited, at least in theory. That’s because there’s no limit to how high a stock price can go, and a short seller realizes a loss when the stock price rises above the price at which it was shorted.

Short sellers also expose themselves to a potential “short squeeze,” a potentially devastating event where other investors aggressively bid up shares as shorts scramble to close their positions. Epic short squeezes from the past involved Piggly Wiggly in 1923, Volkswagen in 2008, and Tesla in late 2019/early 2020.

Melvin Capital was one of several hedge funds on the wrong side of a short squeeze this time around. GameStop’s stock price rose from $18.84 at the close on December 31, 2020, to $347.51 at the close on January 27, 2021—a gain of 1,748% in just 17 trading days.

Melvin’s portfolio lost more than half its value in January and required cash infusions from two other hedge funds to shore itself up.

Short seller, beware.

Lesson 2: Serious Investing Shouldn’t Be a Social Activity

People like to talk about investing. It ranks right up there with chatting about politics, sports, and the weather. Workplace retirement plans are commonplace, so investing is a subject that involves many of us. Twenty-four/seven media coverage provides ample discussion topics.

But there is a line that shouldn’t be crossed. It’s OK to discuss investments, but it’s dangerous to put your money where their mouth is. In many cases, we don’t know much about that quick-to-dispense-with investing “advice.” What’s their background? Are they qualified to offer recommendations so potentially impactful to your finances?

We all know someone who is quick to point how they doubled their money in their favorite stock … but fails to mention that all their other positions are underwater. These people likely won’t tell you when to get out, and they almost certainly won’t be there to help when their advice runs you astray.

Today, online forums have replaced cocktail parties as the venue where stock tips are shared. In fact, the GameStop short squeeze was driven in a social-media-fueled frenzy by retail traders who were members of the WallStreetBets forum, a group with more than 8 million members.

Consider the 24-year-old graduate student at the Massachusetts Institute of Technology profiled by the Wall Street Journal who turned a $500 bet on GameStop into $203,411. He cashed out with a significant sum that he says he’ll use to help with school expenses. But he did so with some regrets. As the Journal wrote:

He already misses the community he had been a part of, if only briefly. “It felt like I was part of something bigger,” he said.

Thankfully, he cashed out when he did. As we shall see next, that “camaraderie” could have cost him six figures.

Lesson 3: The Party Always Ends …

All great investment cycles tend to follow the same general path:

  • The cycle starts with an opportunity to buy a previously shunned asset at a price less than its intrinsic value.
  • The price approaches fair value as more investors buy into the underlying fundamentals.
  • The price climbs to levels considered “expensive” as past gains draw the attention of more investors who put aside skepticism.
  • Euphoria takes over as the price soars where it’s completely decoupled from fundamentals and reality. Nobody cares because … good times forever, man!

And then it ends.

Sometimes it comes about because people get wise and take some profits. Other times it’s because of forced selling. And sometimes it’s simply because the cycle exhausted itself, running out of those incremental buyers needed to keep bidding prices ever higher.

The dot-com party ended. The housing party ended. And it looks like the GameStop party has ended. It closed at $52.40 on February 12, 2021, down 85% from its closing price of $347.51 on January 27, 2021.

… Usually with a Hangover

Unfortunately, someone always buys at the top and is left holding the bag.

After the dot-com bubble burst, it took the Nasdaq 15 years to recover its prior peak. During and after the housing crisis, many lost their homes.

The Wall Street Journal profiled some GameStop traders who lost big. One was a 25-year-old security guard in Virginia who took out a $20,000 personal loan with an 11.19% interest rate to buy GameStop stock. He bought at $234 a share. His stake is down about 80%, and he still needs to make his monthly loan payments.

Conclusion

The GameStop mini-mania is unique only in the names and dates involved. Risky speculation is as old as the hills. And it will remain as long as market activity is influenced by the ups and downs of human psychology.

Renowned investor and author Benjamin Graham once commented that “[t]he individual investor should act consistently as an investor and not as a speculator.”

We couldn’t agree more.

 

Discuss goals banner

James Walden, CFA

As a partner and the firm’s Chief Investment Officer, James Walden strives to maximize our clients’ long-term, risk-adjusted portfolio returns. This includes determining strategic and tactical asset allocations, as well as specific investment analysis and prudent rebalancing. Jim is also a partner and management team member. His expertise includes advanced investment research and valuation, and he is passionate about his role in helping clients reach and exceed their financial goals.